Measurement of Inflation in India -

7/29/2019 Measurement of Inflation in India -

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Measurement of Inflationin India

Issues and associatedchallenges for the conduct of

monetary policy...


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What is inflation? Inflation rate is the rate at which prices of goods and

services increase in its economy.

It is an indication of the rise in the general level of pricesover time.

A sample set or a basket of goods and services is used toget an indicative figure of the change in prices, which we

call the inflation rate.


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Price Index

Aprice index is a normalized average (typicallya weighted average) of prices for a given class of goods or services ina given region, during a given interval of time.

Price Indices

WPI CPIIndustrial workers

Urban non-manual

Agricultural Labour

Rural Labour


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Wholesale Price Index(WPI)

WPI is the index that is used to measure the change in the averageprice level of goods traded in wholesale market.

In India, a total of 435 commodities data on price level is trackedthrough 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 withthe shortest possible time lag only two weeks.

The Indian government has taken WPI as an indicator of the rate ofinflation in the economy.


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Consumer Price Index(CPI)

CPI is a statistical time-series measure of a weighted average ofprices of a specified set of goods and services purchased byconsumers.

It is a price index that tracks the prices of a specified basket ofconsumer goods and services, providing a measure of inflation.

Under CPI, an index is scaled so that it is equal to 100 at a chosenpoint in time, so that all other values of the index are a percentagerelative to this one.


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Difference between WPI and CPI

WPI CPI

Measure the temporal price change ofwholesale transactions of allcommodities in the country

Measures the average price ofconsumer goods and servicespurchased by households

The weights of items have beenassigned in proportion to their sharein the total value oftransaction(output) in the economy

Weights are assigned in proportion totheir share in the consumptionexpenditure of the family of industrialworkers in the selected centers

Measures inflation at each stage of

production

Measures inflation only at final stage

of production

Does not include the services beingoffered

Includes the services being offered


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Laspeyres Index

The Laspeyres price index is an index formula used in pricestatistics for measuring the price development of the basket of goodsand services consumed in the base period.

The question it answers is how much a basket that consumersbought in the base period would cost in the current period.

It is defined as a fixed-weight, or fixed-basket, index that uses thebasket of goods and services and their weights from the base period.


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Substitution Bias of Laspeyres Index

Unfortunately, Laspeyres does not take into account that as pricesincrease the consumer will usually buy less of the product, orpurchase a cheaper product, in either case reducing the sales volumeof the original product.

As a result of this oversight, Laspeyres index systematicallyoverstates inflation.


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Calculation of Laspeyres Index

Year Quantity 1 Price 1 Quantity 2 Price 2

2007 100 $1.00 50 $5.00

2008 200 $1.25 75 $6.00

Enter values into the following formula:Laspeyres = 100 *(cost of base year basket in 2008/cost of base year basket in2007).Laspeyres = 100 * ((100 * $1.25 + 50 * $6.00) / (100 * $1.00 + 50 * $5.00))

Perform the calculations.

Laspeyres = 100 * ((200 * $1.25 + 75 * $6.00) / (100 * $1.00 + 50 * $5.00))Laspeyres = 100 *((250 + 450) / (100 + 250))Laspeyres = 100 * (700/350)Laspeyres = 100 * 2Laspeyres = 200


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Trends in CPI & WPI Differ in terms of their weighting pattern

CPIs lag behind WPI by a month

Price of services

Metals and alloys


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Month WPI (Base Year 2004-05 = 100) CPI (Base Year 2001=100)

january 2010135.2

148.04

february 2010 135.2 146.32

march 2010 136.3 146.32

april 2010 138.6 146.32

may 2010 139.1 148.04

june 2010 139.8 149.76

july 2010 141 153.21

august 2010 141.1 153.21

september 2010 142 154.07

october 2010 142.9 155.79

november 2010 143.8 156.65

december 2010 146 159.23

january 2011 148 161.81

february 2011 148.1 159.23

march 2011 149.5 159.23

april 2011 152.1 160.09

may 2011 152.4 160.95

june 2011 153.1 162.68

july 2011 154.2 166.12

august 2011 154.9 166.98

Monthly WPI and CPI


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100

110

120

130

140

150

160

170

180

WPI

CPI

Monthly Values of WPI and CPI


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Month

CPI-IW (Base Year

2001=100)

CPI-AL (Base : CPI-

1986-87= 100)

CPI-UNME (Base : CPI-

1984-85= 100)

CPI-RL (Base : CPI-

1986-87= 100)

january 2010 172 542 671 542

february 2010 170 538 666 538

march 2010 170 536 663 536

april 2010 170 538 667 538

may 2010 172 540 672 540

june 2010 174 547 679 547

july 2010 178 554 696 554

august 2010 178 557 696 557

september 2010 179 562 701 562

october 2010 181 566 705 565

november 2010 182 570 710 569

december 2010 185 581 719 580

january 2011 188 589 588

february 2011 185 584 584

march 2011 185 585 584

april 2011 186 587 587

may 2011 187 592 592

june 2011 189 598 597

july 2011 193 604 604

august 2011194

610

610

Monthly values


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100

200

300

400

500

600

700

WPI

CPI-IW

CPI_AL

CPI-UNME

CPI_RL

Monthly values of each CPI and WPI


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Comparison of weights of some important

commodities in WPI and CPICommodities Wgt. in WPI Wgt. in CPI

Food Articles 18.4 47.58

Minerals 1.52 -

Fuel & Power 14.91 9.49

The graphs show a diverging trend between the WPI and CPI in short run.This is due to difference in weightages given to different commodities likeFood articles, Minerals, metals & Alloys and Fuel and Power in the two indexesas shown above in the table.

Services which form a significant proportion in consumption of Indianconsumers, are not included in WPI whereas they are included in CPI. Becauseof greater services such as transportation, packaging, home delivery, cleaning

etc getting embedded into retail and wholesale prices, the two indexes differ.


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CPI is the preferred measure worldwidebut India uses WPI

Available for all commodities and for major groups, sub-groupsand individual commodities

Available at high frequency WPI inflation at fortnightly lag vsCPI inflation at monthly lag. Then two components of WPI arereleased on a weekly basis giving weekly information on inflationtrends


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CRITICISM FOR WPI

INCOMPLETE PRODUCT COMPOSITION/ COVERAGE

Non-inclusion of services

Following a fixed weighting scheme while the economy isundergoing major structural changes

Use of gross transactions data and wholesale data rather thandata on final purchases

FREQUENCY OF REPORTING

OUTDATED BASE YEAR


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COMPOSITION/ COVERAGE (1/2)

Non-Inclusion of Services

WPI does not capture price movementin services sector which has a largerand increasing share of GDP

Practical problems in including

services in WPI calculation:1. Availability of data on different

services sectors on a continuousbasis

2. Identifying services purchasedby producers and servicespurchased by consumers

3. Need for mixing and matchingdata collected from administeredprices as well as from marketprices for services rendered

4. Problem of non-tradable services

Following a fixed weightingscheme

Many commodities included in theIndex have ceased to be importantfrom the consumption point of view

Weights and commodity basketsshould be reviewed from time totime- if this is not done properly andperiodically, the WPI number may notbe a true representation of theinflation


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COMPOSITION/ COVERAGE (2/2)

Use of gross transactions data andwholesale data rather thandata on final purchases

Does not properly measure the exact price rise an endconsumerwill experience

157 countries out of 181 countries in the IMF statistics use CPIfor tracking inflation (Economic Survey 2008-2009)

Concept of wholesale price is not clearly defined

In many cases, these prices correspond to farm-gate, factory-gateor mine-head prices

In other cases they refer to prices at the level of primary markets,secondary markets or other wholesale or retail markets

USE OF WHOLESALE DATA


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FREQUENCY OF REPORTING

Question - changing the frequency of WPI series to monthly fromthe weekly system

Currently, a large percentage of items are not reported and thus,DIPP repeats the figures of the previous week

Thus, when inflation is rising, items are under-reported and when

inflation is falling, items are over-reported


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BASE YEAR EFFECT

Base year has considerable influence on the movementof price relatives of the individual commodities and also

on the weighting pattern Seven revisions have taken place introducing the new

base years, viz., 1948-49, 1952-53, 1961-62, 1970-71,1981-82, 1993-94 and 2004-05


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Criteria for selecting base year

NORMAL YEAR: stable year in respect of economic activities likeproduction, trade, etc and their prices. It should not suffer frombusiness cycles

DATA AVAILABILITY: Reliable price data must be reasonablyavailable for the selected base year,

RECENCY: Should be as recent as possible so that by the timerevised series of items and their prices are released, it should nothave outlived its utility, and

NOT OFF THE MARK: Base year for closely related economicindicators should not be widely off the mark


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To capture the recent changes in industrial

structure on account ofliberalization andglobalization, there is a need to have periodicrevisions of WPI numbers, preferably every fiveyears but not later than ten years. The proposedrevision should bring base years of WPI and CPI

numbers much closer to each other.


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REVISIONS IN 2010

2004-05 as base instead of the earlier base of 1993-94

676 items as against 435 items in the previous series

Consumer itemswidely used by the middle class like ice-cream,mineral water, flowers, microwave oven, washing machine, gold andsilver are reflected in the new series of WPI

Change in weights:

Under primary article group of the new WPI, there are 102 items

against existing 98, fuel and power category will remain static at19 while 555 items of manufactured products will be includednow compared to 318 items earlier

Weight of manufactured products went up to 64.97% comparedto 63.75%, while that of primary articles group, including food,came down to 20.12%, against 22.02% earlier


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REVISIONS IN 2010 - IMPACT

Change of weight from 1993-94 to 2004-05 does not significantly alter thetrends in overall inflation

However, inflation based on the new weights exhibit greater volatility thanthe existing series

During the first half of 2008-09 fuel and metal prices (which have higherweights in the constructed index) increased substantially on account of

the sharp increases in global prices and declined sharply during thesecond half

Greater volatility in the two broad groups explains the differences ininflation as per the new weights


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What is the inflation rate we keep readingabout? It is the annual point-to-point inflation rate, which measures the

change in the level of a price index over a full year

Let us say that we have WPI for the beginning and the end of year:

Inflation rate for the year will be = (WPI of end of year WPI ofbeginning of year)/WPI of beginning of year x 100

For example,

Say, WPI on Jan 1st 2010 is 108.33WPI on Jan 1st 2011 is 112.33

Therefore, inflation rate for the year 2011 = (112.33 108.33)/108.33 x 100= 3.69%

That is to say that the inflation rate for the year 2011 is 3.69%


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Calculation of Index and Inflation (1/3)

It is calculated on the principle of weighted arithmetic mean, according tothe Lasperyres formula which has a fixed base-year weighing diagramoperative through the entire life span of the series

Where, I = Index Number of wholesale prices of a sub-group/group/majorgroup/all commodities

Wi: The weight assigned to the ith item/sub-group/group/major group

Ii: Index of ith item/subgroup/group/major group

The WPI Index is composed of three broad heads namelyManufactured

Products, Primary Articles and Fuel Groups with weight 63.75%,22.02% and 14.23% respectively

Let us examine the detailed breakup of the Fuel Groups along with theindexed prices of each of the sub heads:


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Thus the fuel groups index stands at:

= 1597.38/14.23

= 38.74

Similarly the primary articles and the manufactured products index can becalculated and let us take their values as 29.78 and 46.35 respectively

Thus, for week x in the year 20x1,

WPI index = Mfg. prod. Index + Primary articles Index + Fuel Groups index

= 46.35 + 29.78 + 38.74 = 114.87

Similarly, inweek x of the next year, 20x2:

Fuel groups index value is 1614.73/41.2 = 39.16

Corresponding value for the primary articles and manufactured products isat 32.63 and 46.63 respectively



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Thus the value of WPI index is at the end of week x stands at 39.16 + 46.63+ 32.63 = 118.42

Thus the Index has grown by(118.42 - 114.87 )/ 114.87 = 3.09% inweek x of the year 20x2 compared to its value in week x of the year 20x1

This signifies a growth in the wholesale price in India For the week ended x of the year 20x2, the inflation rate in India is at

3.09%



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Point-to-point inflation rate reflects only the difference in prices over twospecific weeks. Hence, if the inflation rate moves up from one week to thenext,

It need not mean that prices have actually moved over that period

It may equally be because there was a fall in the corresponding period ofthe previous year.

Problems with point-to-point inflation

Which Measure of Inflation for Monetary Policy?

For the purpose of targeting of the inflation objective there is a debate onwhich measure of inflation to use and the broad options include,

year on year changes in price indices,

seasonally adjusted month over month changes,

targeting the core component of inflation i.e. eliminating the volatilecomponents from headline inflation.


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Year-on-yearInflation andMonth-over-month (m-o-m)Seasonally

AdjustedInflation

WPI andAlternateMeasures ofCore Inflation


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Core Inflation

Core inflation is a measure of inflation which excludescertain items that face volatile price movements, notably

food and oil Core inflation by eliminating the volatile components

from the headline helps in identifying the underlyingtrend in headline inflation and is believed to predict

future inflation better


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India: Headline Vs Core Inflation


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Volatility in Inflation Measures


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Which is a better measure: Core inflationor Headline inflation

Indian inflation path has been significantly conditioned by twomajor supply shocks, i.e., oil and food. Even the exclusion of these

two items, representing the most conventional measure of coreinflation, does not impart greater stability to the inflation path. Also,such exclusion makes the core measure much less representative,since the common man is primarily affected by food and fuelinflation.


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Which is a better measure: Core inflation

or Headline inflation

Looking at it from a different perspective:

The question should not be whether I buy food and oil, but whetherheadline or core inflation is a better measure of where headlineinflation is likely to settle once overall prices have adjusted to thehigher prices of energy and food. For forecasting purposes, we wantto know not only what (headline) inflation is today, but also, andmuch more importantly, where headline inflation is likely to betomorrow (the medium term). Identifying a measure of underlying

inflation gives us a good head start...


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Effects of high Inflation rates

Increasing inflation usually denotes slowing of economy as prices forfood, commodities and services rise and the currency weakens. Someof the most prominent effects of inflation are:

Increase in costs

Loans becoming costlier

Decrease in returns from investments

Decrease in total portfolio value High taxes

Cut down in working costs by companies

Slow infrastructure growth


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