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Measuring Inflation

 <a href://www.govindam.org> Business School </a>

Inflation is best defined as a sustained increase in the general price level leading to a fall in the value of money. In this section we will concentrate on the measurement of inflation in the UK.

The consumer price index (CPI) is a weighted price index which measures the monthly change in the prices of goods and services.  The spending patterns on which the index is weighted are revised each year, mainly using information from the Family Expenditure Survey. The expenditure of some of the higher income households, and of pensioner households mainly dependent on state pensions, is excluded. As spending patterns change over time, the weightings used in calculating the CPI are altered. The consumer price index is now used as the main official measure of inflation in the UK. It is a weighted price index. The current weights used in the calculation of the price level are summarized in the table below:

Weights used in the consumer price index

The changes in these weights reflect significant shifts in spending patterns of households in the British economy. The weighting attached to food and non alcoholic drinks has declined from 184/1000 in 1988 to just 106/1000 this year. In contrast families are spending proportionately more of their budgets on recreation and cultural activities, hotels and cafés!

Calculating a weighted price index

The following hypothetical example shows how to calculate a weighted price index for a number of categories of consumer spending.

Weights are attached to each category and then we multiply these weights to the price index for each item of spending for a given year.

• The price index for this year is: the sum of (price x weight) / sum of the weights
• So the price index for this year is 104.1 (rounding to one decimal place)

The rate of inflation is the % change in the price index from one year to another. So if in one year the price index is 104.1 and a year later the price index has risen to 112.5, then the annual rate of inflation = (112.5 – 104.1) divided by 104.1 x 100. Thus the rate of inflation = 8.07%.

The inflation target for the UK

The inflation target for the UK economy is consumer price inflation of 2.0%. This inflation target is set each year by the Chancellor and it is the task of the Bank of England (BoE) to meet this target. There is a permitted band of fluctuation of +/- 1%. The inflation target was changed in December 2003. Between May 1997 and December 2003 the inflation target was for CPIX (retail price inflation excluding mortgage interest rates) and the target was 2.5%.

The progress of the UK economy in keeping to the 2% inflation target since the millennium

Limitations of the Consumer Price Index as a measure of inflation

The retail price index is a thorough indicator of consumer price inflation for the British economy but there are some weaknesses in its usefulness for some groups of people.

• The CPI is not fully representative: Since the CPI represents the expenditure of the ‘average’ household, it may be inaccurate for the ‘non-typical’ household. 14% of the index is devoted to motoring expenses - inapplicable for non-car owners. Single people have different spending patterns from households that include children, young from old, male from female, rich from poor and minority groups. We all have our own ‘weighting’ for goods and services that does not coincide with that assigned for the retail price index.
• Housing costs: The ‘housing’ category of the CPI records changes in the costs of rents, mortgage interest, property and insurance, repairs. It accounts for around 16% of the index. Housing costs vary greatly from person to person, from the young house buyer, mortgaged to the hilt, to the older householder who may have paid off his or her mortgage.
• Changing quality of goods and services: Although the price of a good or service may rise, this may be accompanied by an improvement in quality as the good. It is hard to make price comparisons of, for example, electrical goods over the last 20 years because new audio-visual equipment is so different from its predecessors. In this respect, the CPI may over-estimate inflation. The CPI is slow to respond to the emergence of new products and services.

how does India calculate inflation? And how is it calculated in developed countries?

• India uses the Wholesale Price Index (WPI) to calculate and then decide the inflation rate in the economy.
• Most developed countries use the Consumer Price Index (CPI) to calculate inflation.

Wholesale Price Index (WPI)

WPI was first published in 1902, and was one of the more economic indicators available to policy makers until it was replaced by most developed countries by the Consumer Price Index in the 1970s.

WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions. It is also the price index which is available on a weekly basis with the shortest possible time lag only two weeks. The Indian government has taken WPI as an indicator of the rate of inflation in the economy.

Consumer Price Index (CPI)

CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation.

\CPI is a fixed quantity price index and considered by some a cost of living index. Under CPI, an index is scaled so that it is equal to 100 at a chosen point in time, so that all other values of the index are a percentage relative to this one.

Economists Shunmugam and Prasad say it is high time that India abandoned WPI and adopted CPI to calculate inflation.

India is the only major country that uses a wholesale index to measure inflation. Most countries use the CPI as a measure of inflation, as this actually measures the increase in price that a consumer will ultimately have to pay for.

"CPI is the official barometer of inflation in many countries such as the United States, the United Kingdom, Japan , France , Canada , Singapore and China. The governments there review the commodity basket of CPI every 4-5 years to factor in changes in consumption pattern," says their research paper.

It pointed out that WPI does not properly measure the exact price rise an end-consumer will experience because, as the same suggests, it is at the wholesale level.

The paper says the main problem with WPI calculation is that more than 100 out of the 435 commodities included in the Index have ceased to be important from the consumption point of view.

Take, for example, a commodity like coarse grains that go into making of livestock feed. This commodity is insignificant, but continues to be considered while measuring inflation.

India constituted the last WPI series of commodities in 1993-94; but has not updated it till now that economists argue the Index has lost relevance and can not be the barometer to calculate inflation.

Shunmugam says WPI is supposed to measure impact of prices on business. "But we use it to measure the impact on consumers. Many commodities not consumed by consumers get calculated in the index. And it does not factor in services which have assumed so much importance in the economy," he pointed out.

But why is India not switching over to the CPI method of calculating inflation?

Finance ministry officials point out that there are many intricate problems from shifting from WPI to CPI model.

First of all, they say, in India, there are four different types of CPI indices, and that makes switching over to the Index from WPI fairly 'risky and unwieldy.' The four CPI series are: CPI Industrial Workers; CPI Urban Non-Manual Employees; CPI Agricultural labourers; and CPI Rural labour.

Secondly, officials say the CPI cannot be used in India because there is too much of a lag in reporting CPI numbers. In fact, as of May 21, the latest CPI number reported is for March 2006.

The WPI is published on a weekly basis and the CPI, on a monthly basis.

And in India, inflation is calculated on a weekly basis.