Inflation Demystified

-by

Manish Kumar Sharma, MBA(IT), IIIT-Allahabad

Hi my name is Manish and as we proceed further I will be talking about “INFLATION”, an element of economics that decides the fate of under privileged people in a country. Without any further delay let us begin.

There has been increase in the prices of various agricultural commodities in India. The prices of certain items like sugar, rice, wheat, vegetables have increased in the recent past. The government has taken a number of steps to improve the supply and curtail price rise, however to the common man’s misfortune it has not been all that effective so far.

WHAT IS INFLATION?

We all have experienced it from time to time. I remember, as a kid buying ‘THUMS UP’ for Rs. 5 and today we pay Rs. 10 for it - exactly double!! This is when the quality, quantity and taste have remained constant.

For starters I think this was the easiest example to explain what ‘INFLATION’ actually is. Yes you have understood it correctly it is the fact that the money we possess loses it buying capacity over a period of time.

Keeping in mind the range of my readers ‘Inflation’ indicates the price rise of a basket of commodities on a point to point basis. It basically suggests an increase in the cost of living over a period of time e.g. if you buy 10 essential commodities on 1^st January 2007 for Rs. 100. If the same set of commodities costs Rs. 105 on January 1^st 2008, the inflation rate will be at 5%. It means the prices are rising at a rate of 5% per annum.

Inflation is measured by monitoring changes in price indices. The purpose of a price index is to be able to quantify the overall increase or decrease in prices of several commodities rather than the increase or decrease in the price of individual commodities. The means through which the index accomplishes this task is by measuring changes in individual prices and then arriving at a weighted average change for the whole lot. The weights assigned to individual commodities would depend on their relative importance. For instance, how the price of wheat which you might consume every day, changes is obviously more important than, say, changes in the price of footwear.

As I am proceeding I can feel that it is getting a little havier for the starters but I am sure that they will not lose their concentration.

WHAT IS WPI/CPI?

There are broadly two kinds of indices, a Wholesale Price Index (WPI) and a Consumer Price Index (CPI). The former measures the changes in the whole sale prices which may be more important from the producer’s point of views, while the latter measures the changes in retail prices, which are obviously more relevant to the consumer. The Inflation rate in India is calculated on the basis of WPI. For example if the inflation rate reaches 5.2% for a particular week, what it means is that the average level of prices of the commodities tracked by the WPI for that week was 5.2% higher than in the same week, a year ago. It is important to recognize that the inflation rate going down does not mean prices are declining. It only means the rate at which the prices are going up has slowed down.

HOW MANY KINDS OF PRICE INDEX DO WE HAVE IN INDIA?

We have one WPI and three kinds of CPI. These are the CPI for agricultural labour (AL), industrial workers (IW) and urban non manual employees (UNME). The reason why we need so many CPIs is that the basket of goods consumed by the each category is likely to be different from others. For instance, it makes little sense to include the price of suburban train tickets in Mumbai in the CPI for AL, but it might make perfect sense to do so in the CPI for UMNE. Conversely, the weight attached to food groups, especially cereals, would be much higher in CPI (AL), as it is assumed that farm workers will spend a higher proportion of their income on food. It should also be clear from this why the CPIs have different indices, apart from the all-India index.

HOW A PRICE INDEX IS CONSTRUCTED?

The first step is to figure out what all items are to be included or categories should be included. For the WPI, this this will mean all categoies of goods produced or used in the economy. For a CPI the determination of the components is done on the basis of a household survey that establishes consumption patterns. Next, each item would be assigned a weight in the overall index in proportion to its share in the total expenditure in the case of CPI and in proportion to the value of output of that item in the total output of all the goods in the case of WPI. The index reflects nothing but the weighted average of each commodity’s price. An appropriate base year is selected, in which the price of each commodity and hence the overall index, is equated to 100.

This base is then used as a benchmark for future prices. Thus, if wheat costs, say, Rs. 10 per Kg. in the base year and Rs. 15 per Kg. in a subsequent year, the wheat index for the later year would be 150. How much the change in the index of a particular commodity influences the overall index would depend on what its weight is. The greater the weight, the more the impact.

 I hope that till now the stoic starters have learned about Inflation and the rest of the readers have got some additional information about the same. I am closing it here with the hope of meeting you in the next issue of B’cognizance. Till then happy reading...