Inflation & The Cost of Living

Inflation: Definition & Measure

Inflation is defined as a continuous rise in the
general price level
Inflation is measured as the percentage change
in the price level

Pt is the general price level at time t

Computation of General Price Index

Fix the commodity basket on the basis of
importance assigned to various goods and services
by typical consumers for a reference period
Find the prices for each of the goods and services
included in the basket for several periods
including the reference period
Calculate the baskets cost for the all the periods
holding quantity constant
Calculate CPI as

Problems with CPI Measure

Substitution bias
Change in relative prices
Introduction of new goods

Unmeasured quality changes

GDP Deflator vs. CPI

Domestically produced goods vs. goods
consumed by the consumers
Eg. Aircrafts, factory machineries & equipments
Imported goods and services consumed by the
consumers

Fixed basket vs. goods produced in the current

year
CPI is a better measure of cost of living
compared to GDP deflator

Effects of Inflation
Reduces real value of money or purchasing
power
Causes redistribution of income
Anticipated (expected) vs. unanticipated
(unexpected) inflation

Types of Inflation
By source
Demand pull
Cost push
Profit push
Wage push

By intensity
Low inflation
Galloping or very high inflation
Hyperinflation

Deflation

Global Inflation Data for Top 52 Countries; India ranks 33 among 208 Countries

2014

70
60
50
40
30

2014

20
10
0

Source: World Bank

Indian Inflation
Measures of general price level &inflation
Wholesale Price Index (WPI)
Consumer Price Index (CPI)
CPI for Industrial Workers (CPI-IW)
CPI for Agricultural Labourers (CPI-AL)
CPI for Rural Labourers (CPI-RL)
CPI New Series (CPI-NS)

GDP Deflator
Private Final Consumption Expenditure (PFCE)
Deflator

Certain Characteristics
CPI-IW has a broader coverage than the other three CPIs
and is used as a cost of living index for the organized
sector.
GDP deflator though a more comprehensive measure of
price level, it is available only on a quarterly basis with a
lag of 2 months since 1996.
The main problem with WPI is that it does not include
service sector which constitute around 57 percent of Indian
GDP.

Divergence between WPI & CPI

Exclusion of Services by WPI
Weighting patterns vary between CPI and WPI. Food has a larger share in
CPI (46.20 in CPI-IW 2010 base) compared to only 24.31 in WPI. On the
other hand, the fuel group has much higher weight (14.91) in WPI
compared to CPI which is often less than 10 percent (9.49).
Outdated base period: The base period of WPI has been changed to 200405 in and the new series has been launched on Sep 14, 2010. The old
series has 1993-94 as the base year. The new series has been developed
based on the recommendations of the Working Group set up with Prof
Abhijit Sen, Member, Planning Commission as Chairman for revision of
WPI series. The new series has 676 commodities compared to 435 in the
1993-94 based WPI. The CPI-IW base has also been changed to 1982 to
2001 while for CPI-AL and CPI-RL the base period is still 1986-87. The
CPI-NS considers 200 weighted products.

Calculation

Calculation: Laspeyres Formula

Price indices are calculated as
(I W )

I
W
i

i
i

Where Ii are indices for individual commodity groups and

calculated as
pit
i p wi 0
i0
Ii
i wi 0

Where wi0 is the expenditure on ith commodity in the base period

wi 0 pi 0 qi 0