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Inflation&theCostofLiving
Inflation is defined as a continuous rise in the general price level. This means, increases in the
general price level for prolonged time period is considered as inflation. Inflation is measuredas
the percentage change in the price level. The price level or general price level is measured by
price indices and priceindicesareweightedaverageofthe pricesofalargenumberofindividual
products. Thus, if the price level at period
t
is denoted by
Pt
theninflationattime
tiscalculated
P tP t1
as P t1 100 .
The most common price index is Consumer Price Index (CPI). The other important indices are
WholesalePriceIndex(WPI)andGDPDeflator.Apriceindexiscalculatedasfollows:
1. Fix the commodity basket on the basis of importance assigned to various goods and
services by a typical consumer. A commodity will be important ifaconsumerpurchases
more of that commodity. Therefore, that commodity should getgreaterweight.Suppose,
there are only 2 commodities, rice and paper and in a particular year (say 2010) 5 kg of
riceand1rimofpaperissold.
2. Find the prices for each of the goods and services included in the basket for 2013.
SupposethepricesofriceandpaperareRs60/kgandRs100/rim.
3. Now calculate the baskets cost 560 + 1100 = 400. In order to compare prices across
years or compute inflation, the costs of the same basket should be computed for several
years. Suppose the costs turns out to be Rs 450, Rs 475, and Rs 465 for 2011,2012and
2013, respectively. Note that for every year only the prices change for thecalculationof
basket value and not the quantity of goods and services. Here 2010 is the base year and
quantityshouldalwaysbetheoneconsideredforthebaseyear.
Costofthebasketatyeart
4. The CPI can be calculated for each year as I = Costofthebasketatthebaseyear
100 . With the
examplesgivenabove,CPIfor2010,2011,2012and2013willbe100,112.5,118.75and
116.25,respectively.
CPI CPI2010
5. Finally,theinflationratefor2011iscomputedas 2011
100 = 12.5 .
CPI2010
Problems withtheMeasurementofCostofLiving
:theobjectiveoftheconsumerpriceindexisto
measure changes in the cost of living and to actasanindicatorofhowmuchincomeshouldrise
in order to maintain a constant standard of living. However, there are two major problems with
the index as a measure. The first is called the
substitution bias
. It arises primarily for two
reasons. First is the change in relative prices. Generally with price changes consumers
consumption patterns change such that they tendtosubstitutemoreexpensiveproductswithless
expensive ones. However, when a fixed commodity basket is used for every year thenit failsto
reflect changing importance ofgoodsandservicesandthus,eitheroverestimateorunderestimate
theactualcostofliving.
The second reason is
introduction of new goods
. Again, when a new good is introduced
consumers have more variety to choose from and may replace their previous consumption of
certain products with the new ones. However, again a fixed basket does not accommodate such
changesandconsequentreductioninthecostofliving.
The second problem is
unmeasured quality changes
. If the quality of a good deteriorates over a
year then even though the price remains same, the value of money decreases because one pays
the same for less. Alternatively, if quality improves then for the same price, the value money
increases.However,bothcasesarenotreflectedinthemeasurementofconsumerpriceindex.
GDP Deflatorvs.theConsumerPriceIndex
:bothGDPdeflatorandCPIaremeasuresofgeneral
price level. Most often they are found to move close to each other. However, there are two
important distinctions between them which at times make them drift away fromeachother.The
first difference is that the GDP deflator reflects the prices of all goods and services produced
domestically whereas the CPI reflects the prices of a basket of goods and services bought by
consumers. As a result, there are goods and services which are produced domestically but not
consumed by the consumers are included in GDP deflator but not CPI, e.g. aircrafts, factory
machineries or equipments etc. Similarly, there are goods and services consumed byconsumers
but they are not produced domestically, hence, are not included in the GDP deflator. All
imported goods that feature in the CPI do not form part of GDP deflator. Therefore, prices of
importedgoodsincreasethenCPItendtoincreasesubstantiallybutnotGDPdeflator.
The second point of difference is that while CPI considers a fixed basket for the base year and
compares the prices across years, GDPdeflatorcomparesthepricesofcurrentlyproducedgoods
and services with the prices of the same goods and services for the base year. As a result, the
commodity basket keeps on changing every year for GDP deflator reflecting changing patterns
of goodsandservicesproducedinaneconomy.Ontheotherhand,theCPIbasketisoccasionally
changed by the designated authority.GDPdeflatorcanbeabetterrepresentativeofgeneralprice
level prevailing in the economy but is not suitable as a measure of cost of living which CPI is.
Because, as stated above, first of all GDP deflator includes goods which are not consumed by
consumers and also, does not include goods and serviceswhichareconsumedbyconsumersbut
not produced domestically. Further, it includes prices which are not paid bytheconsumersonly
but also by producers and value additions at various levels. An alternative price index is
wholesalepriceindex(WPI)usedinvariouscountriesincludingIndia.
Effects of inflation
: inflation reduces the real valueofmoneyandhence,purchasingpower.Real
value of moneyismeasured by whatit canbuyoritspurchasingpower.Forinstance,purchasing
Re1
power orrealvalueofRe1= pricelevel
.Therefore,higherthepricelevel,loweristherealvalueor
purchasing power of money. Now, given that inflation measures the change in price level,
purchasing power remains same if income and price level change at the same rate. If income
changesatarateslowerthanpricelevel,thenpurchasingpowerdecreases.
Inflation results in redistribution of income. It takes away purchasing power from those who
receive fixed incomes. More specifically inflation transfers money from savers or investors to
debtors. Here, one needs to distinguish between
expected
and
unexpected inflation
. Expected
inflation is the inflation rate that one expects to prevail in future based on all available
informationtillthecurrentperiod.Ontheotherhand,unexpectedinflationischangesintheprice
level that were not forecasted or expected. Most financial dealings or contracts incorporate
expected inflation while calculating the future cash flows. However, if actual inflation turnsout
to be more than the expected one, then the creditors are at a disadvantageous position. For
instance, Mr. A lends Mr. BRs100foroneyearwithaninterestrateof10%.AfteroneyearMr.
A receives Rs 110 from Mr. B. If Mr. As expectedinflationratewas5%thenheexpectedanet
gain of Rs 5 after one year. However, if inflation turns out to be12%,thenMr.Aisatalossby
2%afteroneyearwhileMr.Bwillpaylessinrealterms.
Types of Inflation
: inflation is often classified according to the source of inflationary pressure.
The most common practice is to consider two sources: one, from the demandsideofthemarket
and two,fromthesupplysideofthemarket. Inflationcausedbythedemandsideofthemarketis
called
demand pull inflation
. In thiscase,the demandforgoodsincreasesataratefasterthanthe
supply, hence, price increases. Inflation caused by the supply side of the market is called
cost
push inflation
. This happens when increase in the cost of production leads to increases in the
final prices of the goods and services. Cost push inflation is sometimes attributedtoprofitpush
or wagepush pressures. Profit push pressure occurs when entrepreneurs want to increase their
profit share by increasing price. Similarly, wage push pressure results out of labour unions
pressuretoincreasewageswhichineffectraisesthefinalpricelevel.
Inflation can also be classified into three categories according to severity or intensity.
Low
inflation is characterized by slow and predictable rise in prices. Generally single digit annual
inflation rate can be termed as low inflation thoughitmayvaryacrosscountries.Wheninflation
is in the double or tripledigitrangeof 20, 100 or200percentperyear,thenitiscalled
galloping
inflation
or
very high inflation
. Galloping inflation is relatively common in countries suffering
from weak governments, war or revolution. LatinAmericancountrieslikeArgentina,Venezuela
have gallopinginflationindoubleortripledigits. Evenhigherratesofinflationwithpricesrising
a million or a trillion percent per year are termed as
hyperinflation
. The most thoroughly
documented case of hyperinflation took place in theWeimarRepublicof Germanyinthe1920s.
Between January 1922 to November 1923 the price index rose from 1 to 10,000,000,000. This
implies that if a person had 300,000,000 marks in January 1922, within a period of years its
valuereducedto0.03marks.
In recent years Zimbabwe experienced hyperinflation when
Prices doubled every 24.7 hours in
November 2008 and inflation reached levels of79billionodd%.Theyeventuallystoppedusing
the official currency and switched to the South African Rand or the $US. Aloafofbreadended
up costing $35 million. There are other instances of hyperinflation taking place in Argentina,
Greece,Yugoslavia,Brazil,andMexicotonameafew,inthelast70years.
Deflation
: as inflation seems to be harmful for an economy, is negative inflation or deflation
admirable? The answer most of often is no. Generally, deflation is observed with aneconomy
passing through recession. If recession is accompanied with inflation, then it is termed as
stagflation. During a recession, economy slows down there is less of all sorts of economic
activities including investment and production. When there is less demand for investments,
interest rates are high. Falling prices make real interest rates even higher and further dampens
investment opportunities. The monetary authorities try to bring the nominal rate down, but it
cannot go below zero. Because if interest rates are zero then financial assets are as good as
money and no one will be willing to hold financial assetsandallwealthwillbeheldintheform
of money. However, even at a nominal interest rate of zero, real interestrateispositivebecause
of deflation. Hence, it is difficult to revive investors sentiments. This problem is termed as
liquidity trap where all financial assets are liquefied so that cash is preferred over other assets
and monetary policy stops working. The only solution is for government to intervene to revive
the economic growth process. In recent years, after the Global Financial Crisis of 200709, this
problem resurfacedintheUSeconomywherethemonetaryauthoritiesfacedtheproblemof
zero
lowerbound
ofnominalinterestrates.
Indianinflation
In India we have five primary measures of inflation Wholesale price index (WPI), CPI for
industrial workers (CPIIW), CPI for agricultural labourers (CPIAL), CPI for rural labourers
(CPIRL) and CPI new series (CPINS) from January 2011. Earlier we also had CPI for urban
nonmanual employees (CPIUNME) which has been discontinued. Besides, we also haveGDP
deflator and private final consumption expenditure (PFCE) deflator as measures of implicit
general price level. The WPI inflation isconsideredastheheadlineinflationmeasurebecauseof
its availability at high frequency at aggregate as well as disaggregated levels. However, WPI
does not consider services. CPIs are meant to reflect on the cost of living for a homogenous
group of consumers based on retail prices. CPIIW has a broader coverage than the other three
CPIs and is used as a cost of living index for the organized sector. GDP deflatorthoughamore
comprehensive measure of price level, it is available only on a quarterly basis with a lag of 2
monthssince1996.
The main problem with WPI is thatit doesnotincludeservicesectorwhichconstitutearound57
percent of Indian GDP. Consequently, it tends to lose its representativeness as a measure of
national price level. Second, the divergence between WPI and CPI is widening because of
various reasons. For instance,
weighting patterns vary between CPI and WPI. Food has alarger
share in CPI (46.20 in CPIIW 2010 base) compared to only 24.31 in WPI. On the other hand,
the fuel group has much higher weight (14.91) in WPIcomparedtoCPIwhichisoftenlessthan
10 percent (9.49). Therefore, changes in the prices of food articles will have a much larger
impact on CPI than WPI while changes in the prices of petrol and petroleum products would
have a magnified impact on WPI than CPI. A third problem is outdated base period. The base
period of WPI has been changed to 200405 in and thenewserieshasbeenlaunchedonSep14,
2010. The old series has 199394 as the base year. The new series hasbeendeveloped basedon
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 199394 based WPI. The CPIIWbasehasalsobeenchangedto1982to
2001 while for CPIAL and CPIRL the base period is still 198687.TheCPINSconsiders200
weightedproducts.
In the Indian context a price index is calculated using the formula I =
(IiW i)
i
Wi
where
I
i is the
index number for the
i
th group of commodities and
W
i
th group.
i is the weight attached to the
The price index for each and every commodity group is calculatedusingLaspeyresformulaofI
P
P it wi0
i
i0
wi0
where the ratio of the current period to base period prices of commodity group
i
is
called price relatives and
w
i
0 is the expenditure on the commodity group in thebase period. The
following table contains the major groups included in WPI and the weights attached to them
alongwithacomparisonbetween199394and200405baseperiods.
