INFLATION CONCEPT & CALCULATION

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 prices over time. Since it's practically impossible to find out the average change in prices of all the goods and services traded in an economy due to the sheer number of goods and services present, a sample set or a basket of goods and services is used to get an indicative figure of the change in prices, which we call the inflation rate.

Mathematically, inflation or inflation rate is calculated as the percentage rate of change of a certain price index.

How does India calculate inflation?
In India, inflation is calculated on a weekly basis. India uses the Wholesale Price Index (WPI) to calculate and then decide the inflation rate in the economy.

WPI was first published in 1902, and was one of the more economic indicators available to policy makers until it was replaced by most developed countries by the Consumer Price Index in the 1970s.

WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. In India, a total of 435 commodities data on price level is tracked through 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 with the shortest possible time lag only two weeks. The Indian government has taken WPI as an indicator of the rate of inflation in the economy.

How is WPI (Wholesale Price Index) calculated?
In this method, a set of 435 commodities and their price changes are used for the calculation. The selected commodities are supposed to represent various strata of the economy and are supposed to give a comprehensive WPI value for the economy.

WPI is calculated on a base year and WPI for the base year is assumed to be 100. To show the calculation, let's assume the base year to be 1970. The data of wholesale prices of all the 435 commodities in the base year and the time for which WPI is to be calculated is gathered.

Let's calculate WPI for the year 1980 for a particular commodity, say wheat. Assume that the price of a kilogram of wheat in 1970 = Rs 5.75 and in 1980 = Rs 6.10

The WPI of wheat for the year 1980 is,
(Price of Wheat in 1980 – Price of Wheat in 1970)/ Price of Wheat in 1970 x 100

i.e. (6.10 – 5.75)/5.75 x 100 = 6.09

Since WPI for the base year is assumed as 100, WPI for 1980 will become 100 + 6.09 = 106.09.

In this way individual WPI values for the remaining 434 commodities are calculated and then the weighted average of individual WPI figures are found out to arrive at the overall Wholesale Price Index. Commodities are given weight-age depending upon its influence in the economy.

How is inflation rate calculated?
If we have the WPI values of two time zones, say, beginning and end of year, the inflation rate for the year will be,

(WPI of end of year – WPI of beginning of year)/WPI of beginning of year x 100

For example, WPI on Jan 1st 1980 is 106.09 and WPI of Jan 1st 1981 is 109.72 then inflation rate for the year 1981 is,

(109.72 – 106.09)/106.09 x 100 = 3.42% and we say the inflation rate for the year 1981 is 3.42%.

Since WPI figures are available every week, inflation for a particular week (which usually means inflation for a period of one year ended on the given week) is calculated based on the above method using WPI of the given week and WPI of the week one year before. This is how we get weekly inflation rates in India.

Characteristics of WPI
Following are the few characteristics of Wholesale Price Index:

    * WPI uses a sample set of 435 commodities for inflation calculation
    * The price from wholesale market is taken for the calculation
    * WPI is available for every week
    * It has a time lag of two weeks, which means WPI of the week two weeks back will be available now

How do developed countries calculate inflation?
Most developed countries use the Consumer Price Index (CPI) to calculate inflation. CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation.

CPI is a fixed quantity price index and considered by some a cost of living index. Under CPI, an index is scaled so that it is equal to 100 at a chosen point in time, so that all other values of the index are a percentage relative to this one.

Economists however say that it is high time India abandoned WPI and adopted CPI to calculate inflation.

India is the only major country that uses a wholesale index to measure inflation. Most countries use the CPI as a measure of inflation, as this actually measures the increase in price that a consumer will ultimately have to pay for.

A research paper of prominent economists V Shunmugam and D G Prasad says that CPI is the official barometer of inflation in many countries such as the United States, the United Kingdom, Japan, France, Canada, Singapore and China. The governments there review the commodity basket of CPI every 4-5 years to factor in changes in consumption pattern.

It pointed out that WPI does not properly measure the exact price rise an end-consumer will experience because, as the same suggests, it is at the wholesale level.

The paper says the main problem with WPI calculation is that more than 100 out of the 435 commodities included in the Index have ceased to be important from the consumption point of view.

Take, for example, a commodity like coarse grains that go into making of livestock feed. This commodity is insignificant, but continues to be considered while measuring inflation.

India constituted the last WPI series of commodities in 1993-94; but has not updated it till now that economists argue the Index has lost relevance and can not be the barometer to calculate inflation.

WPI is supposed to measure impact of prices on business. But India uses it to measure the impact on consumers. Many commodities not consumed by consumers get calculated in the index. And it does not factor in services which have assumed so much importance in the economy.