1

Measuring Inflation
The three indicators for measuring inflation are the following ;

1.Consumer Price Index (CPI)

Consumer Price Index (CPI) helps assess the inflation or deflation of an economy. The price
fluctuations indicate how the cost of living would be affected. Plus, it also assesses the
purchasing power of a nation’s currency.

The consumer price index report is calculated based on the changes in the price of the goods
and services in the market basket. This market basket, as mentioned above, contains a set of
goods and services that are widely used by a population. However, the items included in these
baskets vary based on the consumption habits of the nationals.

It is used as an economic indicator that acts as a proxy for the government’s policies,
intending to keep inflation low to improvepurchasing power. The changes in the CPI guide
the government and policymakers to make suitable decisions for the benefit of the
economy.The Consumer Price Index formula used for calculating the price fluctuation of the
market basket’s items is:

As per the formula, in the numerator, we see cost of market basket in current year, which is the
total cost of all goods and services for the present year that can be determined through survey.
It takes into account some products and services as representative of goods that consumers
typically use.

In the denominator, same thing is done but only for the base year. The base year of consumer
price index data is a reference of benchmark against which the change in price for current
year is determined.

Thus, the value obtained is then multiplied with 100 in order to express the value in
percentage. This helps in easy comparison.

Uses
● As an indicator of the economy, it helps policymakers to make informed decisions.
 2

● CPI assesses consumers’ purchasing power. The increase in prices reduces the
purchasing power of the customers and vice-versa.
● The consumer price index equation acts as an adjusting factor, which authorities
consider to determine the change in the wages or decide the minimum wage levels.
● It is used as an index to check the government’s social schemes and adjust the people’s
living costs accordingly.

● Assessing the CPI can also help in adjusting other economic indicators accordingly. For
example, adjusting the monthly/annual income of an employee.

Importance
Let us study the importance of the concept in financial market.

● Inflation study – It is a very good measure to understand the level of inflation prevailing
in the market, the rate at which it is rising, which indicates changes in cost of living of
consumers.
● Monetary policy formulation – It acts as a guide to any changes in monetary policies
through interest rate and money supply adjustment. This will help in keeping inflation
under control and maintain a stable economy.
● Business decisions – These decisions can be related to production, inventory or price
management, policy regarding wage adjustment of labor, etc. They all depend to a great
extent on inflation prevailing in an economy, for which management needs to take
suitable decisions.
● Economic assessment – The country’s financial and economic condition can be assessed
using this index. It is possible to analyse the changes in index pattern and predict the
health of the economy and possible financial situations that may arise in future.

● Predict future trends – Theconsumer price index forecast is frequently used to evaluate
and perdict future trends regarding changes in demand, supply, spending, investment,
etc. These factors play an important role in economic development.

Limitations
Some limitations of the concept are given below:

● Random data collection – CPI is one of the most important factors to assess the level of
inflation occurring or expected to occur in the coming year. Thus, accuracy matters a lot.
However, while calculating the CPI, theprice changes for the current year are gathered
based onrandom sampling.
 3

● Lack of accuracy – The above point means the samples collected and the price
information collected may not necessarily be accurate. For example, the data collected
forconsumer price index forecastmight be more for a certain market or population than
the other. As a result, the computation is likely to be influenced by the population figures,
the amount of data from which is more.

Consumer Price Index Vs Producer Price Index

Both the above are important indicators in an economy that can be used for measurement of
price changes. However, there are some basic differences between them which are as follows;

● The main focus of the former is to measure the price variation of goods consumed by
consumers to show the cost of living. But the main focus of the latter is to measure the
price variation in outputs of domestic producers.
● The former deals with basket of goods typically consumed by any household like, food,
clothing, rent, household, etc. But the basket of goods in case of the latter are those used
by manufacturers like the raw materials, intermediate or finished goods.
● The main purpose of the former is to understand the inflation rate from a consumer’s
point of view but the latter monitors inflation rates or price trends during the different
stages of production and distribution.

● The former is commonly used to make necessary adjustment in wage, any social
security benefits or similar ones that need monetary adjustment due to inflation. But
the latter is commonly used for assessing cost-push inflation, producerpricing strategies
or problems in supply-chain.

2.Wholesale Price Index (WPI)

The wholesale price index number is a measure of any change in the prices of products
before they go to the retailer. The change is compared on a month on month or year on
year basis and is expressed as a percentage.

Given that the main aim is to conclude an reliable inflation rate to the whole territory, the
countries must evaluate the best index that suits them. For instance, the wholesale price
index in economics is used only in a few countries, mainly developing countries that are
manufacturing dominant such as India. While theservice sector dominant countries use PPI.

Advantages
 4

● Represents the overall growth or decline of an economy based on which the reasons can
be sought by conducting micro-level scrutiny.
● The 5-year plan, as made by most countries, is based on the inflation rates calculated
using the WPI.
● It helps the business to make budgets affected by the likely inflation.
● Comparing the goods of different industries helps the government draft policies to
improve underperforming sectors and insight into various sectors to concentrate and
build.
● The industries can compare, analyze their performance with the other products and take
industry-wide measures to improve and build upon.

Disadvantages
● The wholesale price index in economics considers the impact of only a sample of goods
that represent the entire population of goods. Always an inherent risk
● of business exists.
● Since it represents the population, the inflation calculated as a whole using the weighted
average
● may not be accurate.
● Different countries use different products to calculate the WPI. Therefore, it is not always
comparable to other countries.
● It does not serve as the right benchmark for countries dominated by the service sector.

WPI Vs Consumer Price Index (CPI)

● WPI is used to calculate the change in the wholesale price of goods, whereas the CPI
measures the change in the retail cost of products.
● The data for calculation of wholesale price index is collected from the wholesalers,
whereas the data fro CPI is taken from retailers.
● The base year is not the same fro both of them.
● The wholesale price index number only considers the price changes of goods, but CPI
also finds the price changes of services.

3.Producer Price Index (PPI)

Unlike the consumer price index (CPI), the product prices in PPI do not include any taxes,
trade, or transport margins that buyers have to pay. Instead, PPI prices reflect the changes in
production costs. However, these changes eventually get passed on to consumers and are
reflected in CPI. Thus, both PPI and CPI are popular measures of inflation. The US Bureau of
Labor Statistics (BLS) publishes the PPI figures at regular intervals based on the data from
industries operating in the goods-manufacturing sector.

● Producer Price Index (PPI) reflects the overall change in prices of goods and services at
the producer level.
 5

● It includes price changes of inputs, semi-finished products, and finished goods and
services.
● PPI is used to measure the rate of inflation in an economy.
● The Bureau of Labor Statistics (BLS) publishes the PPI figures at regular intervals.
● BLS uses the Laspeyres Index formula to calculate PPI.

● PPI classifies the price changes on the basis of three broad structures – Industry-level
classification, Commodity classification, and Final Demand – Intermediate Demand
(FD-ID).

Classification of Prices in PPI

PPI classifies the price changes based on three broad structures – Industry-level classification,
Commodity classification, and Final Demand – Intermediate Demand (FD-ID).

1. The industry-level PPI classification is done with respect to the changes in the total net
output of an industry. This net output marks the aggregate sales price of products
produced in an industry that is sold outside that sector.
2. Commodity classification refers to the categorization done on the basis of the products
and services. PPI identifies and segregates products of an industry depending on the
overall similarity, composition, and use.

3. FD-ID classification is based on the end-user of the products and services. PPI classifies
the price change as a final demand if the end-users are the customers themselves. On
the other hand, when the products and services reach customers through channels in
between, the price changes are categorized as intermediate demand.

5.GDP Deflator
The GDP deflator is a tool that measures the gross domestic product (GDP) affected by the
change in the price of the products and goods rather than the output of an economy. It
helps read the market’s expenditure pattern and demand behaviors that directly or
indirectly affect a nation’s economy.The deflator considers all goods and services that an
economy produces or delivers in a year and compares the value of the same items with that of
the base year. It differs from a Wholesale Price Index

(WPI), which does not consider the service sector

 6

.The GDP deflator equation measures the change in the annual domestic production due to
changes in price rates in the economy. It measures price inflation/deflation concerning the
specific base year.

● It measures the change in nominal and real GDP during a particular year calculated by
dividing the nominal GDP by the real GDP and multiplying the resultant by 100.
● It is not based on a fixed basket of goods or services but can be modified yearly
depending on consumption and investment patterns.

● The GDP price deflator of the base year is 100.

The formula to derive GDP deflator equation is:

Here,

● Nominal GDP
● is evaluated using the current market prices.

● Real GDP indicates an inflation-adjusted measure of all goods and services produced by
an economy in a year.

Uses
The calculation is based on the GDP deflator base year gives analysts, world leaders, and
citizens important data points to consider about the state of the economy.Let us discuss some
of the best uses that exhibit the true meaning of a GDP deflator through the discussion
below:
 7

● It reflects the prices of all domestically produced goods and services in the economy to
measure inflation effectively.

● It includes prices of investment goods, government services, and exports while excluding
costs of imports.
● A deflator automatically indicates important changes in consumption patterns or the
introduction of new goods or services.
● It acts as an effective mode of study to identify patterns and check the inflation rate over
the years. In addition, it also identifies the expenditure preference and behavioral patterns
of consumers, which helps detect the changes in the demandand consumption cycle.

● The spending pattern of the population highly influences the GDP deflator.

GDP Deflator vs CPI

While the GDP price deflator considers the value of all goods, products, and services produced
in the country, Consumer Price Index (CPI) is based on a limited basket of goods and services.
As a result, the latter does not represent the entire economy.

While CPI data is available monthly, the deflator comes with a quarterly or yearly lag after the
GDP is released. Thus, the deflator cannot track monthly inflation changes, which impacts its
dynamic usefulness. Nevertheless, let us look at the differences between the deflator and CPI
through the comparison table below:

Category GDP Deflator CPI

Exhibits Reflects the price of all domestically Reflects the price of all domestically
produced goods and services. produced goods and services.

Consideration It contains the prices of domestic Imported goods are also included
goods in the same.

Assigns value It assigns changing weights over Assigns fixed weights to prices of
time as the composition of different goods. It’s
GDP changes. computed using a fixed
basket of goods.

Comparison The deflator compares the price of It compares the price of the fixed
the goods and products of a basket of goods and services
 8

particular year against the to the price of a basket in the

value of the same goods and base
products in the base year.