17. Inflation - Concept and Measurement

Objectives:

After studying this lesson, you will be able to understand,

The defination of inflation.

The different methods of measurement of inflation

The whole sale price index

The Consumer price index

17.1 Introduction

17.2.Definition of Inflation

17.3 Measurement of Inflation

17.3.1 Consumer Price Index

17.3.2 Whole Sale Price Indices or Product Price Indices

17.3.3 Commodity Price Indices

17.3.3 Core Price Indices

17.4 Issues in Measurement

17.5 Summary

17.6 Check your progress

17.7 Key concepts

17.8 Self Assessment questions

17.9 Answers to check your progress

17.10 Suggested Readings

17.1 Introduction:

Dear student, in an earlier lesson we studied trade cycles and their phases. In this lesson

you are going to learn the concept of inflation and how do we measure the inflation. We

know that a rise in price is generally called as inflation. But we do not aware about the

computational methods of inflation. It means that if there is inflation in an economy, how

much inflation is there and how will it compute, all these things are unknown aspects to

us. Therefore, the present lesson is devoted to understand clearly what is inflation and

how inflation is measured. What are the different methods which are available to

compute it. Since 1700 to 1930’s unemployment problem was the main concern of then

economists but during 1930’s unexpectedly inflation has become a problem of the same

intensity that of unemployment. Thus since 1930’s the problem of inflation attracted the

attention of economists and policy makers. So let us now concentrate on the concept of

inflation and its measurement in an economy.

17.2 Definition of inflation:

There are many definitions of inflation. By inflation most people understand a sustained

and substantial rise in prices. For example:

Crowther defines inflation as a state in which the value of money is falling.

Harry G Johnson, “We define inflation as substantial increase in prices”.

Milton Friedman writes ”By inflation I shall mean a steady and sustained rise in

prices”

According to Rowan, “inflation is the process of price increase”

Prof Samuelson puts it as “Inflation occurs when the general level of prices and

costs is rising”.

Thorp and Quandt, opine that it is of great help to define inflation in terms of

obseravable, phenomenon and for his reason the process of rising prices should be

considered as inflation.

This type of definition of inflation is, however, beset with certain difficulties. The first is

that there may be price rises which are not inflationary. There may occur a crop-failure or

some other natural calamities like flood or earthquake. This will cause a sharp decline in

food supply as a result of which there would be some rise in prices to ration the reduced

supply. Or let us take another situation in which the economy is moving from depression

to a higher level of employment. There would certainly be some increase in prices due to

an increased demand for goods and services. These two cases of price rises cannot be

regarded as inflation because these are self-limiting and at the same time do not pose any

serious policy problem.

To some economists, Inflation is a pure monetary phenomenon, while to others, it

is a post-full employment phenomenon.

Keynes mentions the following four related terms while discussing the concept of

inflation:

Reflection: is a situation of rising prices, deliberately undertaken to relieve a depression.

With rising prices, employment, output and income also increase till the conomy reaches

the full employment ceiling.

Inflation: it occurs when prices rise after the stage of full employment is reached in the

economy.

Disinflation: when prices are falling due to anti-inflationary measures adopted by the

authorities, with no corresponding decline in the existing level of employment, output

and income, and result is disinflation.

Deflation: it is a condtion of falling prices accompanied by a decreasing level of

employment, output and income. Deflation is just the opposite of inflation.

On different grounds, economists have classified inflation into various types. A few

important categories are presented in the following:

According to the Rate of Inflation:

a) Moderate Inflation- Creeping inflation and Walking Inflation.

b) Running Inflation

c) Galloping Inflation

d) Hyper Inflation

According to the nature of time-period of occurrence:

a) War-time Infaltion

b) Post-War Infaltion

c) Peace-time Inflation

According to the Government’s reaction:

a) Open Inflation

b) Repressed Inflation

According to the Causes:

a) Credit Inflation

b) Deficit Inflation

c) Scarcity Inflation

d) Profit Inflation

e) Foreign trade Inflation

f) Tax Inflation

g) Cost or Wage Inflation

h) Demand Inflation

17.3 Measurement of Inflation:

Inflation can be measured by following different methods, but there are certain

difficulties in measuring by using each one of the methods. Shall we choose a wholesale

price index or a consumer price index? The government of Japan relied on wholesale

price index to show that the rapid economic growth of 1960-62 was not inflationary,

while the opposition made use of consumer goods price index to show that the position

was reverse. A similar problem arises when we have to choose between a price index

which includes taxes and subsidies and the one which excludes taxes and subsidies.

The difficulty with the use of a price index for measuring inflation is that most price

indices do not take into account of changes in the quality of the product. There are many

instances in which the price of a particular good has increased with an improvement in its

quality. A new higher priced model of a particular model car will certainly yield better

service than an old one and thus an increase in its price cannot be called inflationary.

Above discussion reveals that there are two important methods in measurement of

inflation, they are : Consumer price Index and Whole sale Price Index. Let us now have

a glance at these methods.

17.3.1 Consumer Price Index:

The Consumer Price Index measures prices of a selection of goods and services

purchased by a consumer. The inflation rate is the percentage rate of change of a price

index over time. For instance, in January 2009, the Indian Consumer Price Index was

202.4, and in January 2010 it was 211.1. The formula for calculating the annual

percentage rate of inflation in the CPI over the course of 2009 is

211.1-202.4/202.4*100 = 4.28%

The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the

general level of prices for consumers rose by approximately four percent in 2009.

17.3.2 Whole Sale Price Indices or Producer price indices (PPIs):

Whole sale price index measures average changes in prices received by domestic

producers for their output. This differs from the CPI in that price subsidization, profits,

and taxes may cause the amount received by the producer to differ from what the

consumer paid. There is also typically a delay between an increase in the Producer Price

Indices and any eventual increase in the Consumer Price Index. Producer price index

measures the pressure being put on producers by the costs of their raw materials. This

could be "passed on" to consumers, or it could be absorbed by profits, or offset by

increasing productivity.

Other methods of measurement of inflation:

17.3.3 Commodity price indices, which measure the price of a selection of commodities.

In the present, commodity price indices are weighted by the relative importance of the

components to the all in cost of an employee.

17.3.4 Core price indices: because food and oil prices can change quickly due to

changes in supply and demand conditions in the food and oil markets, it can be difficult

to detect the long run trend in price levels when those prices are included. Therefore most

statistical agencies also report a measure of 'core inflation', which removes the most

volatile components (such as food and oil) from a broad price index like the CPI. Because

core inflation is less affected by short run supply and demand conditions in specific

markets, central banks rely on it to better measure the inflationary impact of current

monetary policy.

17.4 Issues in measurement:

Measuring inflation in an economy requires objective means of differentiating changes in

nominal prices on a common set of goods and services, and distinguishing them from

those price shifts resulting from changes in value such as volume, quality, or

performance. This single price change would not, however, represent general inflation in

an overall economy. To measure overall inflation, the price change of a large basket of

representative goods and services is measured. This is the purpose of a price index, which

is the combined price of many goods and services. The combined price is the sum of the

weighted average prices of items in the basket. A weighted price is calculated by

multiplying the unit price of an item to the number of those items the average consumer

purchases. Weighted pricing is a necessary means to measuring the impact of individual

unit price changes on the economy's overall inflation.

The Consumer Price Index, for example, uses data collected by surveying households to

determine what proportion of the typical consumer's overall spending is spent on specific

goods and services, and weights the average prices of those items accordingly. Those

weighted average prices are combined to calculate the overall price. To better relate price

changes over time, indexes typically choose a "base year" price and assign it a value of

100. Index prices in subsequent years are then expressed in relation to the base year price.

Inflation measures are often modified over time, either for the relative weight of goods in

the basket, or in the way in which goods and services from the present are compared with

goods and services from the past. Over time adjustments are made to the type of goods

and services selected in order to reflect changes in the sorts of goods and services

purchased by 'typical consumers'.

When looking at inflation economic institutions may focus only on certain kinds of

prices, such as the core inflation index which is used by central banks to formulate

monetary policy.

Most inflation indices are calculated from weighted averages of selected price changes.

This necessarily introduces distortion, and can lead to legitimate disputes about what the

true inflation rate is. This problem can be overcome by including all available price

changes in the calculation, and then choosing the median value.

17.5 Summary

Inflation is commonly understood as a situation of substantial and rapid general increase

in the level of prices and consequent deterioration in the value of money over a period of

time. The behaviour of general prices is measured through price indices. The trend of

price reveals the course of inflation or deflation in the economy. A price rise which is

unforeseen and uncorrected is inflationary. Thus, inflation is statistically measured in

terms of percentage increase in the price index, as a rate per cent per unit of time-usually

a year or a month. Usually, the wholesale price index numbers are used to measure

inflation. Alternatively, the consumer price index or the cost of living index number can

be adopted in measuring the rate of inflation.

17.6 Check your progress

State whether the following statement is True or False

1. The cost of living index number cannot be adopted in measuring the rate of

inflation.

2. Inflation is statistically measured in terms of percentage increase in the

price index, as a rate per cent per unit of time-usually a year or a month.

Most inflation indices are calculated from weighted averages of selected price

changes.

3. Core inflation, which maintains the most volatile components (such as food

and oil) from a broad price index like the CPI.

4. The Consumer Price Index measures prices of a selection of goods and

services purchased by a consumer.

5. ”By inflation I shall mean a steady and sustained rise in prices” writes by

Crowther.

17.7 Key concepts

Creeping inflation

Walking Inflation.

Running Inflation

Galloping Inflation

Hyper Inflation

War-time Infaltion

Post-War Infaltion

Peace-time Inflation

Open Inflation

Repressed Inflation

Credit Inflation

Deficit Inflation

Scarcity Inflation

Profit Inflation

Foreign trade Inflation

Tax Inflation

Cost or Wage Inflation

Demand Inflation

Creeping inflation

Walking Inflation.

17.8 Self Assessment questions

1. Explain in brief the different definitions of inflation

2. Enlist the methods of measurement of Inflation

3. Do you suggest the WPI method is better than the CPI method of

Measurement of Inflation

17.9 Answers to check your progress

1.False 2. True 3. False 4. True 5. False

17.10 Suggested Readings

Ackley Gardner : Macro economic theory

Ward R A: Monetary theory and policy

Rana & Verma : Macro economic analysis

Hajela TN: Monetary economics

Ghatak : Monetary economics in developing economies

Gupta SB : Monetary policy in india

http//www.enwikipedia.org/inflation#measures