Module IV- Inflation

8/8/2019 Module IV- Inflation

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Inflation basics

What is Inflation?

Measures of Inflation.

Economic Effects of Inflation


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What is Inflation

A persistent and appreciable rise in price level.

Difficult to define precisely.


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Measures of inflation

CPI

WPI

GDP deflator


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Effects of inflation

Depends on how far the groups affected can anticipate inflation.

Those who correctly anticipate inflation and are able to protect

themselves from the loss of income and wealth that wd otherwise

occur are able to protect themselves from the hurt in the process.

If people are able to increase their income and market value of

wealth as fast as the prices rise, is not hurt by inflation.

But this has to result automatically from inflation-e.g a money wage

rate increase that results from a COL adjustment and not for any

other reason. If the person has worked greater no. of hrs to offset this inflation,

his real income and wealth may be unchanged. However, this has

been achieved by a sacrifice of leisure a loss.


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Effects of inflation on distribution of income and wealth

Infln affects mostly those with higher incomes when incomes

are measured to include the changes in net worth caused by

infln.


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General Price level

3 diff measures of price level.

Consumer Price Index(CPI)

Wholesale Price Index(WPI)

GDP Deflator


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Each is a wted average of several prices and is

presented as an index no.

CPI signals changes in prices facing the consumer.

WPI the changes in price facing the producer.

GDP Deflator signals the overall national price

changes.

Each in its own way provides a measure of inflationin the economy.

None is a perfect measure.


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CPI

The CPI is a measure of the overall cost of gds and

svs bought by a typical consumer.

It is used to monitor the changes in the cost of living

over time.

When the CPI rises, typically the family has to spend

more money to maintain the same living standards.


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CALCULATION OF CPI

Fix the basket

Find the price

Compute the basket cost

Choose a base year

Compute the Index

Compute the inflation rate


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We need the consumption basket in the base yearand

Price relatives for each item in the given yr--------------

to calculate the weights W.Wn. This can be used to calculate the index.

In practice, cannot take all the consn items. Hencetake groups of items- food, tobacco, fuel and light,

housing etc. with further sub-groupings e.g withinfood- pulses, cereals etc. Even here, not necessary toinclude all items in the calculation; if prices of groupsof items show closely similar movements, only one of

them needs to be included in the index calculation.


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E.g in the vegs and fruits gp, only a couple of vegs and a couple offruits can be selected for monitoring price movements; prices ofothers wd presumably move more or less in unison with theselected items.

The consumption basket data comes from family budget surveys

carried out from time to time. These surveys yield estimates ofcommodity composition of consumption expenditures of a typicalfamily in a specified population gp.These surveys are conducted bythe CSO and are done every 5 yrs.

Price data is obtained from the retail outlets by a large staff of fieldinvestigators.

The base yr is changed from year to year so that account can betaken of the changes in tastes, appearance of new items in theconsn basket.

Without such updating, the index wd lose its usefulness as anapproximate measure of the COL.


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CONSTRUCTION OF CPI

Item

(0)

Qty 2000-01-

base year

(1)

Prices 2000-01-

base year

(2)

Prices 2009-10

Current year

(3)

Price relative

2009-10=Prices

2009-10/Prices

2000-01*100

(4)

RICE 15 Kg Rs.3/kg Rs. 4/kg 133

WHEAT 10kg Rs.2/kg Rs.3/kg 150

MILK 30 ltrs Rs.3/ltr Rs.5/ltr 167

COTTON CLOTH 5 mtrs Rs.8/mtr Rs.12/mtr 150

HOUSING A 2-room

house

Rs.100/p.m Rs.200 p.m 200


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CONSTRUCTION OF CPI

Item Wi= base year

weights=poqo/

pioqio

(5)

Price relative

2009-10=Prices

2009-10/Prices

2000-01*100

Wi* Price

relative (4*5)

(6)

Laspeyres CPI=

wi

Pi/Pio*100=

6

(7)

R(ICE 45/295=0.15 133 19.95

WHEAT 20/295=0.07 150 10.5

MILK 90/295= 0.30 167 50.1

COTTON CLOTH 40/295= 0.14 150 21

HOUSING 100/295= 0.34 200 68 169.55


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EXP.in 2000-01=pi qi=Rs.295

WEIGHTS

Share of milk in total exp in 2000-01= 90/295= 0.30

Wmilk=exp on milk in base pd/ total exp in basepd=pmilk qmilk/ pi qi= 90/295=0.3

Similarly,W rice=0.15, Wwheat=0.07, cloth=0.14,housing=0.34, The weights sum to unity.

Assume the base year weights hold in the current year

also. This is a crucial assumption in the construction ofthe CPI.

What it means is that the consn basket and theproportionate share of each item in the basket does notchange from the base year to the current year.


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Then calculate the Price relatives.PR= Current year P/ Baseyear P*100.

This tells us the increase in the P of each item in the consnbasket between the base year and the current year.

Price Relative cloth= p1 cloth/po cloth*100=12/8*100= 150.

Thus, between 2000-01 and 2009-10, price of cloth has risenby 50%.

We need a composite index to know what is the increase in

the cost of the basket in 2009-10 compared to 2000-01. Forthis, we multiply the weights by the price relatives and sumup to obtain a weighted average for the entire basket.

Laspeyres CPI=I= wi Pi/Pio*100=169.55

This means that between the base year and the current year,

the cost of the entire basket has gone up by 69.55%.


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Points regarding CPI:

CPI covers all gds and svs entering the consn

basket(including imported goods). However food and

fuel prices may be left out due to their volatility.

The relevant price is the retail Price.

Quantity weights are constant and are the base year

weights (col5) . In India, CPI is reported with a 2month time lag.

It is constructed for CPI AL, CPI Urban Industrial

workers, CPI urban non-manual employees.


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WPI

Methodology same as CPI construction.

Only the data changes.

Column 0 consists of a much larger basket of goods.

The wholesale price index consists of over 2,400

commodities. The indicator tracks the price

movement of each commodity individually.

Unlike the CPI, it considers only goods and excludesall services.

In column 1, it considers the transactions of each

item in the wholesale mkt.


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WPI

In column 2 and 3, it takes into consideration

wholesale and not retail prices.

In column 5, weights are based on the value of

transactions in the various items in the base year.Like in CPI, the base year weights are fixed.

Then, calculation of price relatives and Laspeyres

index is the same as the CPI.


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Points regarding WPI

It includes only goods(including intermediate goods) andno svs.

It can be interpreted as an index of prices paid byproducers for their inputs.

Relevant price is the wholesale price.

Quantity weights are constant.

Articles covered- The basket consists of Primary articles,Manufactured articles, Fuel Power, light and lubricants.

In India, it is reported with a 2 week lag.

In India, movements in WPI are used to measure theinflation and CPI, the cost of living changes in theeconomy.


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GDP DEFLATOR

Revision of gdp concepts:

Nominal GdP= Value of final gds and svs in current

prices.

Real GDP= Value of final gds and svs in constant

prices.

GDP Deflator= Nominal GDP/ Real GDP*100

A managers interest is in real GDP. It allows directcomparison of physical output from one year to the

next, since a constant measuring device has been

used.


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Good or

service(item)

Base P Base Q Current P Current Q

X1 2 40 3 60

X2 8 90 10 150

X3 80 100 90 110

X4 70 120 80 130


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Base pd GDP=17200

Nominal GDP= Current q*current P= 21980

Real GDP= Current Q* base price= 19220.

Growth in nominal GDP= 21980-

17200/17200*100=27.79%.

This is partly due to an increase in Q and partly due

to increase in P. Growth in real GDP= 19220-

17200/17200*100=11.74%.

This reflects increase in Q alone.


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By holding price constant at the base level, we haveeliminated the impact of any change in P during thispd in the estimation of real GDP growth.

What was the increase in P during this pd that weeliminated?

The GDP deflator gives this and is obtained by-

Nominal GDP/ Real GDP*100.

Here GDP deflator= 21980/19220*100=114.36. Hence the increase in prices during this pd, which we

eliminated in the real GDP growth calculation was14.36%


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Symbolically, GDP deflator= ptqt/ poqt.

Hence, unlike CPI and WPI, qty weights are not fixed. Theyvary each yr.

We come to know of the qty produced of gds and svs of eachyr only at the end of the yr. hence GDP deflator comes with aone year time lag.

It is the most comprehensive measure of changes in thegeneral price level as it considers all domestically produced

final gds and svs. Prices considered are retail prices.

Calculate GDP deflator by dividing GDP mp (current) byGDPmp(base) *100 for the last 10 yrs.

Also look at CPI-AL, CPI-IW, CPI-UNM and WPI for last 10

yrs. WPI is a single series expressed as an annual average.


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CPI time lag is 2 months.

With rapid change in consn habits, using a fixed qtyweight for an extended pd of ime is questionable.

WPI suffers from a serious flaw. It does not consider svs.

With svs accounting for more than 50% of Indias GDP,this is a serious omission.

Also inclusion of intermediate gds leads to a cascadingeffect on prices.

WPI however is available with the least time lag of 2weeks.

GDP deflator is the broadest indicator of changes in thedom price level. But comes with a longer time lag. Alsothe data is subject to frequent revisions with revision in

GDP figures.


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WPI


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WPI


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WPI

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Module IV- Inflation

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