Explained: How is inflation measured?

Inflation indicators are crucial tools for policymakers, investors, and consumers as they monitor and measure inflationary pressures in the economy.

Inflation is the rate at which an economy's overall price level of goods and services increases over time. This means that as inflation grows, the purchasing power of money falls, requiring more money to purchase the same quantity of goods and services. Inflation can be induced by several circumstances, including increased money supply, increased demand for goods and services, or decreased supply of goods and services. The inflation rate of a country is often used to assess inflation, which is the percentage change in the price level of goods and services over a certain period, such as a year or a quarter.

An inflation indicator is a metric or index that tracks changes in the overall price level of goods and services in each economy over time. Inflation indicators are crucial tools for policymakers, investors, and consumers because they monitor and measure inflationary pressures in the economy.

There are several indicators that can be used to measure inflation. Some of the most common indicators of inflation include:

Consumer Price Index (CPI)

The Consumer Price Index (CPI) is a metric that records the average price of a basket of goods and services purchased by households over time. It is extensively used to measure the degree of inflation in an economy and is frequently used as a benchmark for central banks' inflation targets.

The CPI is computed by selecting a representative basket of goods and services that are commonly purchased by households and tracking the prices of those goods and services over time. The weight of the basket items is determined by their respective importance in household spending. The weights are derived from household expenditure surveys, which provide data on the average consumption patterns of households in each country or region.

The following formula is used to calculate the CPI:

CPI = (Total cost of goods and services in current year / Total cost of goods and services in base year)x100.

The base year is a reference year that serves as the index's starting point. The CPI is often reported as an index number with a base year index of 100.

For example, suppose a basket of goods and services costs Rs 100 in the base year of 2010, and the same basket costs Rs 120 in the current year. 

The current year's CPI would be computed as follows:

CPI = (Rs 120 / Rs 100) x 100 = 120

This means that the basket of products and services prices have increased by 20 per cent since the base year.

Because it reflects increases in the cost of living for households, the CPI is an essential measure of inflation. Policymakers use it to track inflation patterns and alter economic policies accordingly. Businesses and consumers use the CPI to modify their prices and incomes to keep up with inflation.

Producer Price Index (PPI)

The Producer Price Index (PPI) is a statistical measure of the average change over time in the prices received by producers for their goods and services. It tracks the average price increases in goods and services at the producer or wholesale level before they are sold to consumers.

The PPI is determined by selecting a representative basket of goods and services produced by firms and measuring their prices over time. The basket components are weighted depending on their relative importance in the economy's total production of goods and services. The weights are based on data acquired from surveys of enterprises that generate goods and services.

The PPI is calculated using the following formula:

PPI = (Total revenue from basket of goods and services in current year / Total revenue from basket of goods and services in base year) x 100

The base year is a reference year that serves as the index's starting point. The PPI is often reported as an index number with a base year index of 100.

For example, imagine a basket of goods and services creates Rs 100 in revenue in the base year of 2010, and the same basket of goods and services generates Rs 120 in income in the current year. 

The current year's PPI would be calculated as follows:

PPI = (Rs. 120 / Rs. 100) x 100 = 120

This means that revenue from the basket of products and services has increased by 20 per cent from the baseline year.

Because it represents changes in the prices received by producers for their goods and services, the PPI is an essential measure of inflation. Policymakers use it to track inflation patterns early in the production process and forecast how these trends will affect consumer prices later. Businesses and investors use the PPI to foresee changes in their production costs and modify their pricing strategies accordingly.

GDP deflator

The GDP deflator measures the overall price level of an economy's goods and services. It is a wide measure of inflation that considers all commodities and services generated in an economy, including those produced for consumption, investment, and government use.

Divide the nominal GDP (the total value of all goods and services produced in an economy at current market prices) by the real GDP (the total value of all goods and services produced in an economy at constant prices) and multiply by 100.

GDP deflator = (Nominal GDP / Real GDP) x 100

The GDP deflator is a broad measure of inflation that captures the change in the entire price level of goods and services produced in an economy. In contrast to other inflation measures, such as the Consumer Price Index (CPI) and the Producer Price Index (PPI), which only evaluate changes in the prices of a specified basket of goods and services, the GDP deflator considers all commodities and services produced in an economy.

For example, if an economy's nominal GDP is Rs 1,000 billion and its real GDP is Rs 800 billion, the GDP deflator would be:

GDP deflator = (Rs 1,000 billion / Rs 800 billion) x 100 = 125

This means that the whole price level of goods and services generated in the economy has risen by 25 per cent since the base year for calculating real GDP.

The GDP deflator is a key economic statistic since it adjusts nominal GDP figures for inflation, offering a more realistic picture of economic growth over time. Policymakers also use it to track inflation patterns and alter economic policies accordingly.

Wholesale Price Index (WPI)

The Wholesale Price Index (WPI) is a measure of the wholesale price of items in an economy. It is an indicator that tracks changes in the prices of items sold in bulk to other businesses and retailers by wholesalers.

The WPI is computed by taking a weighted average of the prices of a basket of commodities and assigning a weight to each item in the basket based on its relative importance in the broader wholesale market. Food, fuel, and raw materials are among the commodities included in the basket to reflect diverse sectors of the economy.

The WPI is calculated using the following formula:

WPI = (Total value of the basket of goods in the current period / Total value of the basket of goods in the base period) x 100.

The base period is a reference period used to calculate the index. The WPI is often given as an index number, with the base period index set to 100.

Assume the total value of the basket of products in the base year 2010 is Rs 1000 and the total value of the same basket of goods in the current year is Rs 1200. The WPI for the current year would be computed as follows:

WPI = (Rs 1200 / Rs 1000) x 100 = 120

This means that the basket of goods' wholesale price level has increased by 20 per cent since the base year.

The WPI is an important economic indicator since it indicates changes in wholesale pricing, which can eventually lead to changes in consumer prices. Policymakers and businesses use it to track inflation trends and modify economic policies and pricing strategies accordingly.