Measures of Inflation

Measures of Inflation

Multiple inflation measure: WPI, GDP Deflator and CPI

Wholesale Price Index (WPI) Calculation

In this method, a set of 676 commodities and their price changes are used for the calculation. Individual commodities, and as a result, groups and subgroups have weight-age. On a broader level, the 676 commodities are grouped into Primary Articles, Fuel, Power, Light & Lubricants and Manufactured Products.

These commodities represent various strata of the economy and give a comprehensive WPI value for the economy. WPI is calculated on a base year 2004-05 and WPI for the base year is assumed to be 100. The data of wholesale prices of all the 676 commodities in the base year and the time for which WPI is to be calculated is gathered.

Measuring inflation using WPI

If we have the WPI values of two time zones, say, beginning and end of year, the inflation rate for the year will be,

{(WPI of end of year - WPI of beginning of year)}/WPI of beginning of year x 100

For example, WPI on Jan 1st 2008 is 106.09 and WPI of Jan 1st 2009 is 109.72 then inflation rate for the year 2009 is,

i.e., (109.72 - 106.09)/106.09 x 100 = 3.42%

Inflation rate for the year 2009 is 3.42%.

Drawbacks of WPI

* WPI does not measure properly the exact price rise an end-consumer will experience.

* Service sector is a dominant contributor to India's GDP. Services like Education, health, housing and entertainment are not included in WPI

* Many commodities included in the index have ceased to be important from the consumer point of view.

* It is supposed to measure the impact of prices on business but in India it is used to measure the impact on consumers

Types of GDP and Inflation

GDP Deflator (Pbt)

It is measured as the ratio of nominal GDP to real GDP.

Nominal GDP (PYt)

In a nominal GDP, inflation is not taken into account or consideration. It is evaluated on the basis of the current market price.

PYt= ∑ptqt

Real GDP (Ybt) - Real GDP is computed by taking the market price of some base year. By measuring the nominal GDP of a base year price level, the real GDP is calculated.

Ybt = ∑pbqt

GDP Deflator Index using base year b

(Pbt) = PYt/ Ybt * 100

Inflation is measured as the percentage increase in the GDP Deflator from the beginning of the period to the end

π bt+1 = (Pbt+1 - Pbt)/ Pbt

Measurement Issues

In order to choose a measure of inflation that monetary policy will focus on, three issues need to be addressed:

 Choice of a reference population: This is the most critical decision because a single price index doesn't measure the impact of price changes on the entire population. Thus a target population needs to be chosen whose price index should not move very differently from those of others.

 Selection of weights: The distribution of weights should be as close to the present consumption basket of the target population as possible.

 Measurement of Prices: Prices that are used for calculating index should be measured properly, and they should effectively reflect the consumption basket. Moreover, the data should be timely and reliable.

The two most basic formulae used to calculate price indices are the Paasche index (PP) and the Laspeyres index (PL). They are defined as:

P = Relative index of the price levels in two periods

t0 = Base period (usually the first year)

tn = Period for which the index is computed

As per IMF working paper (Core Inflation Measures and Statistical Issues in choosing among them - Mick Silver, 2006), a measure of core inflation should be:

 timely;

 credible (verifiable by agents independent of the central bank);

 easily understood by the public;

 not significantly biased with respect to the targeted measure;

 be computable in real time;

 be forward-looking in some sense;

 be robust and unbiased;

 have a track record of some sort;

 have some theoretical basis;

 be familiar and understandable to the public; and

 not be subject to revisions

Methodology to measure CPI

Methodology to measure CPI - Industrial Workers

The Labour Bureau is the competent authority to ascertain the CPI for industrial workers under the Minimum Wages Act, 1948. Presently under 2001 base year, 78 industrial centres are chosen based on the industrial importance.

Constituents of CPI-IW

The main constituents of Consumer Price Index for Industrial Workers are weighting diagrams, Retail price data and House rent data.

Weighting Diagram - The primary process of collecting data in the 78 Industrial centres is carried out by National Sample Survey Organisation (NSSO). The weighting diagram for the compilation of index is on the basis of average