Inflation Measurement

2. Overview
1. How the Price Indices (WPI or CPI) are
constructed.
2. Calculating WPI & CPI and the Inflation
Rate.
3. Correcting economic variables for the
effects of inflation.

3. Three Measures Of General
Price Level
 Consumer Price Index(CPI) – Based on
the purchases of an Industrial worker/
Agri. Laborer
 Wholesale Price Index (WPI)– Based on
Producers prices on a chosen bundle of
commodities
 GDP Deflator-Ratio of Nominal GDP and
Real GDP

4. Measuring the Cost of Living
1. To determine the cost of living index,
Ministry of Industry & Ministry of
Labour first identifies a “market
basket” of goods and services the
typical consumer buys.
2. Ministry of Labour surveys consumers
to determine what they buy
(commodity basket) and, annually, the
overall cost of the goods and services
they buy - CPI.

5. Measuring the Cost of Living
1. The Consumer Price Index (CPI) is used to
monitor changes in the cost of living (i.e.
the selected market basket) over time.
When the CPI rises, the typical family has to
spend more rupees to maintain the same
standard of living.
2. The goal of the CPI is to measure changes
in the cost of living. It reports the
movement of prices not in rupee amounts,
but with an index number.

6. What’s in the CPI’s Basket?
Hypothetical Example
Food
18.0%
Household
10.0%
Alcohol
5.0%
Recreation
10.0%
Clothing
7.0%
Health
4.0%
Transportation
18.0%
Shelter
28.0%

7. What is an Index Number?
IrvingFisher(1867-1947)
An indexnumber expresses the value
of some entity (such as price or
quantity)
at a given periodof time in absolute
number formbut related to a base
period set arbitrarilyto 100.

8. Overview
1. how the Consumer Price Index (CPI) is
constructed.
2. Calculating Price Index and the
Inflation Rate.
3. Problems in measuring the cost of
living.
4. Correcting economic variables for the
effects of inflation.

9.  Suppose that in 2014 all you bought wascoffee and rice.
 Coffee was Rs 10.00 per cup andyou bought 365 cups.
 Rice was Rs 30.00 per Kg andyou bought 50 kg.
THE CPI -- A SIMPLE EXAMPLE

10.  In this example, we can treat 2014 as the “base period” of
reference year.
 The CPI in 2015 would answer the question “How much
would your total spending change (relative to 2014) if you
bought the same quantity of coffee and rice in 2015 as in
2014?
THE CPI -- A SIMPLE EXAMPLE

11. Suppose
- Price of a cup of coffee remains the same in 2015 as in
2014 (Rs 10 per cup), but
Rice rise to Rs 40.00 per Kg.
- What’s the value of the CPI in 2015?
THE CPI -- A SIMPLE EXAMPLE

12. - Total spending in 2014:
- 365 cups of coffee@Rs10 = Rs 3650
- 50 kg of rice @ Rs 30 = Rs 1500
Total Rs 5150
THE CPI -- A SIMPLE EXAMPLE

13. THE CPI -- A SIMPLE EXAMPLE
- Total spending in 2015
(if you buy the same stuff):
- 365 cups of coffee @ Rs10 = Rs 3650
- 50 kgs of rice @Rs 40 = Rs 2000
Total Rs 5650

14. The CPI in 2015 = 5650/5150*100 = 109.7
Suppose the Cost rises to Rs. 6000 in 2016
The CPI in 2016 =6000/5150*100
= 116.5
THE CPI -- A SIMPLE EXAMPLE

15. Calculating the Consumer Price Index and the
Inflation Rate
1. Determine what goods are most important to
the typical consumer: Fix the Basket
2. Find the prices of each of the goods and
services in the basket for each point in time:
Find the Prices
3. Use the data on prices to calculate the cost of
the basket of goods and services at different
times: Compute the Basket’s Cost
4. Designate one year as the Base Year, which
is the benchmark for yearly comparison.

16. Calculating the CPI & the Inflation Rate
5. The final step includes using the CPI to calculatethe InflationRate, which is:
◦ the percentage change in the price index fromthe precedingperiod
6. AnotherExampleforpractice:
◦ Base Yearis 2009
◦ Bundle of goodsin 2009 = Rs1,200
◦ The same bundlein 2010 cost = Rs1,236
◦ CPI = (1,236 ÷ 1,200) X 100= 103
◦ Prices between2009 & 2010increasedby 3%

17. The previous series with base 1981-82 covered a basket of 447 commodities drawn from 3
distinct sub-sectors namely, (i) primary sector which include food articles and raw materials
(mostly agro non-food articles and minerals);
(ii) fuel/ power sector which includes coal, petroleum products and electricity; and
(iii) manufactured sector which includes food products, beverages, tobacco, textiles, wood,
paper, leather, rubber and plastic, chemicals, non-metallic minerals, basic metals, machinery,
transport equipments and other miscellaneous manufactured products.
The series is compiled, constructed and reported on a weekly basis.
Wholesale Price Index

19. Source: Das, P. And George, A.T. (2017), Comparison of Consumer and Wholesale Price Index: An Analysis of
Properties and Sources of Divergence, RBI Working Paper No 5

21. The movements in retail prices are monitoredin respect of 4 different segments of the
population based on theirlocation & consumption behaviour - 4 distinct seriesof Consumer
Price Index Numbers:
(1) Consumer Price Indexfor Industrial Workers, CPI-IW, withbase 1982; (covers260 commodities)
(2) ConsumerPrice Indexfor Urban Non-Manual Employees, CPI-UNME, base 1984-85; (covers
180 cdties)
(3) ConsumerPrice Indexfor Agricultural Labourers, CPI-AL, withbase 1986-87; (covers180
commodities) and
(4) Consumer Price Indexfor Rural Labourers, CPI-RL, withbase 1986-87(covers180
commodities). The CPI-RLwas introducedin November 1995.
Price Index & Inflation

22. Price Index & Inflation
The existing WPIseries with base 1993-94, 1999-2000, 2004-5 has
been reviewedby a Working Group. Each Group has suggesteda
new base year and incorporatedthe impact of structural changes in
the economy and the consequent changes in the relative importance
of the commodities constituting the basket.

23. 100
1
1
x
P
P
P
t
t
t
t 






 -
=
-
-
p
Inflation: A Formal Definition
This definition represents the statistic that is reportedwhen we
hear stories about the rateof inflation in the press, or on the news.
Thisdefinitionisanexpostmeasureof inflation: It tellsushow priceschangedbetweenyesterdayand
today.

30. Overview
1. How the Consumer Price Index (CPI) is
constructed.
2. Calculating Consumer Price Index and the
Inflation Rate.
3. Correcting economic variables for the
effects of inflation.

31. The Consumer Price Index Vs the GDP Deflator
1. The CPI:
◦ includes only consumption goods
◦ includes the cost of imports
◦ is a fixed bundle of goods (old)
2. The GDP Price Deflator:
◦ includes all final goods and services
◦ excludes imports
◦ Uses more recent bundle of goods
(new)
Y = C + I + G + X - M

32. Overview
1. How the Consumer Price Index (CPI) is
constructed.
2. Calculating Consumer Price Index and the
Inflation Rate.
3. Problems in measuring the cost of living.
4. Correcting economic variables for the
effects of inflation.

33. Correcting Economic Variables for the Effects of Inflation
1. Price indexes are used to correct for the
effects of inflation when comparing rupee
figures from different times.
2. When some rupee amount is
automatically corrected for inflation by
law or contract the amount is said to be
indexed for inflation.
◦ e.g., Central Govt. Wage Contracts, Wages &
salaries of organized industry/service
employees, Railways, NREGS wages etc.

34. Correcting Economic Variables for the Effects of Inflation
To convert (inflate) past wages
and prices into current terms:
Current Year Rupees =
Past Year Nominal Value X [(Price index in
current year) ÷ (Price index in past
year)] = [ (Wt-1) X (Pt) ÷ (Pt-1)

35. Correcting Economic Variables for the Effects of Inflation
To convert (deflate) current wages and
prices into past year terms:
Value in Past Year Rupees =
Current Year Value X [(Price index in past
year) ÷ (Price index in current year)] = [Wt
X Pt-1 ÷ Pt]

36. Real andNominal Interest Rates
Interest represents a payment in the future for a
transfer of money in the past.
1) Nominal interest rate:
The rate that the bank pays in current value.
2) Real interest rate:
The interest rate corrected for inflation
Real interest rate = Nominal – Inflation

37. Real & Nominal Interest Rates
z Example - Assume:
1. You borrow Rs1,000 for one year.
2. Nominal Interest rate was 15%.
3. During the year inflation was 10%.
z The real interest rate is:
15% - 10% = 5%
• Inflation risk makes some lenders
offer adjustable-rate loans
• (e.g. Housing n Car Loans etc.)

38. Inflation Vs Deflation
Debate

40. Inflation
Should it be zero or
+ve or
-ve?

42. Inflation
• Disinflation is a reduction in the positive
inflation rate, e.g. Europe, USA in 1980s in
India in the late 1990s,
• Deflation is a sustained decrease in the
price level (a negative inflation rate), e.g.
Japan in 1990s, USA in 1930s
• Hyperinflation is a very high rate of inflation
– Brazil experienced inflation over 1000% during
1970s & 1980s, Germany between WW1 and
WW2, Hungry after WW1 periods.

43. Hyperinflation
• Hyperinflation is a very high rate of inflation
– Case Study:Germany between WW1 and WW2.
– For e.g. Price of newspaper rose from 0.3 marks
in January 1922 to 1 mark in May 1922 to 8
marks in October 1922 to 100 marks in fall of
1923, to 1000 marks in September 1923. Then
in end 1923 prices took off 2000 marks Oct 1 to
20000 marks on Oct 15 to 1 million marks Oct
29 to 15 million on Nov 9 to 70 million on Nov
17.
– In Dec everything suddenly stabilised

44. Hyperinflation
• Hyperinflation
– When inflation per month crosses 30
percent.
– Israel, Hungry, Mexico, Argentina, Brazil,
Chile, Russia, Zimbabwe, Venezuela,
Turkey
– To keep Friends do not lend/borrow in
times of hyperinflation

49. Beginning End
End
Price/Initial
Price
Avg.
Monthly
Inflation
Avg
Monthly
Money
Austria 01/10/21 01/08/22 70 47 31
Germany 01/08/22 01/11/23 1x10+10 322 314
Greece 01/11/43 01/11/44 4.7x10+6 365 220
Hungary I 01/03/23 01/02/24 44 46 33
Hungary II 01/08/45 01/07/46 3.8x10+27 19,800 12,200
Poland 01/01/23 01/01/24 699 82 72
Russia 01/12/21 01/01/24 1.2x10+5 57 49

51. Types of Inflation
• Demand Pull Inflation
• Cost Push Inflation
•wage (or input price) push
•profit push

52. Demand-Pull Inflation
Aggregate Output
AS
AD AD’
A sustained rise
in the price
level caused by
increases in
aggregate
demand

53. Cost-Push Inflation:
Wage or Profit Push
• A sustained rise in the
price level caused by
reductions in
aggregate supply
• The combination of
inflation and a falling
level of output has
come to be called
“stagflation”
Aggregate Output
AS
AD AS’

54. Anticipated Versus Unanticipated
Inflation
• A major issue is whether
workers can accurately
anticipate changes in the price
level
– Workers seek to anticipate
inflation so that the purchasing
power of wage contracts is
maintained
• The extent to which workers
can anticipate inflation
determines the effects of
inflation on them in the
economy

55. Why is Inflation So Unpopular?
• As an economic problem, inflation is
widespread
• Workers’ wages rarely keep up with
inflation (real wages fall)
• Those on fixed incomes are seriously
affected (pensioners)
• Long-term contracts are difficult to
negotiate (Fixed interest loans etc.)

56. Problem with deflation?
• Real burden of debt
goes up (Debt-
Deflation Spiral)
• Price uncertainty – profits fall
• High real interest rates

57. Inflation & Output Link
4 high inflation – faster increases in prices –
if it leads to higher profits then the
output will rise and subsequently inflation
could fall
Deflation & Growth
4 Negative inflation –> falling prices –
falling profits -> output will fall –
leading to recession

58. How to control Inflation?
 Tightening Money Supply
 Structural changes by reducing supply
constraints
 Tightening Fiscal Deficits