Measures of Inflation

What are “Measures of Inflation”?

Inflation can be defined as a sustained increase in the overall general level of prices of goods and services in an economy over time. Inflation in an economy is measured as an annual percentage (%) increase (i.e. % increase on a year earlier) in some price index – such as the Consumer Price Index (CPI), GDP deflator, etc. – which adequately reflects the overall inflation in an economy.

Measures of Inflation

To compute CPI, each item (goods and services) is usually weighted in proportion to its importance in the ‘fixed’ representative basket and these weights are usually based on surveys of familiar expenditure in an economy.

The percentage change in the CPI provides a sound measure of the rate of consumer price inflation in an economy i.e. how rapidly the cost of living is rising for the average household or consumer in an economy.

The CPI measure of inflation is used for inflation-targeting purposes and for judging the effectiveness of monetary policy in keeping inflation in check. A marked or unexpected rise in this measure of inflation in an economy usually leads to rising interest rates, a drop in private investment, and falling bond prices and stock prices.

The Producer Price Index (PPI), measures inflation from the point of view of producers in the economy. It captures the price movements of goods and services at the wholesale level and measures the average change in selling prices received by domestic producers for their output.

The Wholesale Price Index (WPI) measures the change in the price of a representative basket of wholesale goods in an economy. It covers only goods and not services, therefore, the prices of services are excluded.

The WPI focuses on the price movements of goods that are bought by corporations/businesses, rather than consumers, and reflects the inflation in the industrial sector of an economy.

The GDP Deflator, defined as the ratio of nominal GDP to real GDP, is an indicator of the overall inflation in an economy, as it reflects changes in prices of all goods and services included in the GDP of a country (i.e. changes in prices of domestically produced output). It does not reflect import prices, unlike the CPI. Basically, the GDP deflator is a broader measure of inflation than CPI.

Core Inflation is calculated by excluding temporary volatile factors, such as prices of food and energy prices, from a relevant price index, such as the CPI. This measure of inflation is computed because food and energy prices are subject to extreme volatility due to changes in supply and demand conditions in these commodity markets. This measure of inflation is a sound indicator of the underlying weakness or strength of domestic demand in an economy.

Consumer Price Index and Inflation

Given below is a workout of the CPI and inflation (on the CPI measure) in Country A for Year 2. Weights are assigned to each category (for example food, alcohol, and housing among others) of spending, per their relative importance or share in consumption of households. A CPI is calculated for each year using these weights.

The annual rate of inflation in the above example is 3%, which is the change in the CPI from Year 1 to Year 2.