# How Is Inflation Calculated?

Posted in Finance Articles, Total Reads: 13839 , Published on February 08, 2012

Before we get down to brass tacks with regard to calculating inflation, let us first acquaint ourselves with the concept of inflation. Inflation is defined as an increase in the general price level. Inflation rate of a country is the rate at which price of goods and services increase in its economy.

However, since the calculation of above mentioned ‘increase in price of goods and services’ is practically impossible given the gigantic number of goods and services which are present, a sample set or basket of goods and services is used to arrive at an indicative figure of the change in prices, which is defined as the inflation rate. For the purpose of calculating inflation, the price indices which are prominently used are Consumer Price Index (adopted by countries like USA, UK Japan and China) and Wholesale Price Index (adopted by India).

In India, the monetary policy of RBI aims at maintaining a stable inflation rate. In order to choose a measure of inflation that the monetary policy would focus on, three issues need to be addressed:-

1. In any country, no one price index will measure the impact of price changes on the entire population, thus a target population needs to be chosen.
2. The weights in the index need to be chosen. This distribution should be as close to the present consumption basket of the target population as possible.
3. Prices that go into the indicator should be measured properly, effectively reflect the consumption basket and the data should be timely and reliable.

Based on these criteria, the RBI focuses on developments in the Wholesale Price Index (WPI). However, the Consumer Price Index (CPI) is referred to when the WPI is not able to reflect the true picture due to high volatility in prices. This multiplicity of inflation indices available in India has often been described as problematic and often argued upon. The justification for the same, in a compendium, has been given by the RBI Governor D. Subbarao as quoted:-

In India, we have one Wholesale Price Index and three Consumer Price Indices. There are ongoing efforts at the technical level to reduce the number of consumer price indices, and I believe the technical issues are not insurmountable. But that still will not give us a single representative inflation rate for an emerging market economy with market imperfections, diverse geography and 1.2 billion people.”

Let us have a look at both these price indices at first hand and understand why both of them act as supplementary to reflect the true inflation rate.

WHOLESALE PRICE INDEX (WPI)

Wholesale Price Index is the primary index used by India to calculate inflation (read headline inflation). The WPI consists of a basket of 676 commodities (revised from 435 with base year 1993-94) and their price changes are used to calculate the value of the index. The base value of the index is taken to be 100 with base year 2004-05. The revised WPI numbers have been adopted in September 2010. The percentage change in the value of the index over a specified period reflects the inflation rate.

THE REVISED WPI INDEX, WITH WEIGHTS 2004-05 = 100

As is clear from the above table, all the commodities in the WPI are divided into 3 broad categories viz. Primary articles, Fuel and power and Manufactured products. However, nowhere there is the composition of services which contribute to a major chunk in the country’s GDP. The WPI figures are available every week. Inflation for a particular week (which generally means inflation for a period of one year ended on the given week) is calculated by comparing WPI value for the given week to the same week one year before. Let us exemplify this process to get a better understanding:-

Calculation of WPI value – WPI is calculated on a base year and WPI for the base year is assumed to be 100. To show the calculation, let us assume the base year to be 2000. The data of wholesale prices of all the 676 commodities in the base year and the time for which WPI is to be calculated is gathered.

Let us calculate WPI for the year 2010 for a particular commodity, say rice. Assume that the price for a kilogram of rice in 2000 = Rs. 20 and in 2010 = Rs. 25. Therefore, the WPI for the year 2010 is :-

(Price of rice in 2010 – Price of rice in 2000) / (Price of rice in 2000) * 100 i.e. (25 – 20) / (20) * 100 = 25

Since WPI for the base year is assumed as 100, WPI for 2010 will become 100 + 25 = 125. In this way individual WPI values for the remaining 675 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 weightage in accordance with their influence in the economy.

Calculation of Inflation – If we have WPI values for two time zones, say beginning and end of the year, the inflation rate for the year will be :-

(WPI at end of year – WPI at beginning of year) / (WPI at beginning of year) * 100

For example, WPI on Jan 1 2010 is 125 and that on Jan 1 2011 is 133.75 then inflation for the year 2011 would be :-

(133.75 – 125) / (125) * 100 = 7%. Thus we say that inflation for the year 2011 is 7%.

CONSUMER PRICE INDEX

The overall CPI is meant to measure the cost of a representative basket of goods and services consumed by an average household. CPI numbers are widely used as a macro-economic indicator of inflation, as a tool by governments and central bank for inflation targeting and for monitoring price stability, and as deflators in the national account. The CPI numbers currently presented at the national level pertain to only specific segments of population viz. Industrial workers, agricultural laborers and rural laborers. Hence the CPI numbers do not reflect a true picture of the price behavior of the country.

To overcome these shortcomings, India launched a new Consumer Price Index on Feb 18, 2011 that combines data from rural and urban areas and includes sectors that weren’t part of the existing gauge. The index uses 2010 as the base year with a starting value of 100. The new index also analyses price trends in services, which account for about 60% of India’s GDP but weren’t covered in the previous CPI. All India weights of CPI (Rural), CPI (Urban) and CPI (Combined) are as under:-

 New series of CPI—All India weights Sub group/group Rural Urban Combined (Rural+Urban) Cereals and products 19.08 8.73 14.59 Pulses and products 3.25 1.87 2.65 Milk and milk products 8.59 6.61 7.73 Oils and fats 4.67 2.89 3.9 Egg, fish and meat 3.38 2.26 2.89 Vegetables 6.57 3.96 5.44 Fruits 1.9 1.88 1.89 Sugar etc 2.41 1.26 1.91 Condiments and spices 2.13 1.16 1.71 Non- alcoholic beverages 2.04 2.02 2.03 Prepared meals etc 2.57 3.17 2.83 Pan, tobacco and Intoxicants 2.73 1.35 2.13 Food, beverages and tobacco 59.31 37.15 49.71 Fuel and light 10.42 8.4 9.49 Clothing and bedding 4.6 3.34 4.05 Footwear 0.77 0.57 0.68 Clothing, bedding and footwear 5.36 3.91 4.73 Housing 22.53 9.77 Education 2.71 4.18 3.35 Medical care 6.72 4.34 5.69 Recreation and amusement 1 1.99 1.43 Transport and communication 5.83 9.84 7.57 Personal care and effects 3.05 2.74 2.92 Household requisites 4.48 3.92 4.3 Others 1.12 0.99 1.06 Miscellaneous 24.91 28 26.31 All Groups 100 100 100

SOURCE: Central Statistics Office, Ministry of Statistics and Programme Implementation, Govt. of India.

A key difference between CPI and WPI is the weightage each index gives to different segments. For instance, the new WPI gives 65% weight to manufactured goods. The food and food products account for only 24.3% of WPI. In contrast CPI has 46.2% weight in food and food products, while manufactured products account for a much lower weight. This makes CPI indices more susceptible to volatility in the food prices.

WPI or CPI?

The answer to this question would require a Daniel come to judgement. Both these indices have been extensively used as macro-economic indicators for the country. So to suggest which method is as fit as a butcher’s dog would be a difficult call. WPI numbers are available every week and it has a wider variety of commodities as compared to CPI. However CPI reflects the consumption bundle of households, and is thus a more reliable measure of inflation. It includes the price of services that are not included in any other measure of inflation.

Today policy decisions taken for monetary actions by the RBI consider WPI as a headline indicator. If the dissemination of the CPI improves, RBI too may consider using it as the headline indicator, in keeping with worldwide practice.

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