The Inflation Rate

Introduction to Inflation

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects the erosion in the purchasing power of money. A chief measure of price inflation is the inflation rate.

The immediate effect of inflation is the value of rupee/dollar (based on the country you are staying) decreases at par with inflation. That means the purchasing power of your ‘money’ decreases. If you want to understand it better, consider the below example. Say, on 1^st January 2010 price of 1 KG of wheat is INR 30. If the inflation raises 10% annually, then the price of 1 KG wheat after 1 year will be INR 33 {30 + (30 x 10%)}. That means, you need INR 33 to buy the same 1 KG wheat after 1 year just because inflation is 10% annually. In other words, you can’t buy the same 1 KG wheat with your INR 30 money anymore, i.e. purchasing power of your 'money' got reduced.

What is Price Index & WPI?

Inflation rate of a country is the rate at which prices of goods and services increase in its economy. 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.

Inflation rate is calculated as the percentage rate of change of a certain price index. A price index is a normalized average (typically a weighted average) of prices for a given class of goods or services in a given region, during a given interval of time. The widely used price indices for inflation rate calculations are Consumer Price Index (adopted by countries such as USA, UK, Japan and China) and Wholesale Price Index (adopted by countries such as India).

In India, WPI is a basket of commodities divided into three major groups - Primary Articles; Fuel, Power, Light & Lubricants; and Manufactured Products. These are again broken up into smaller sub-groups. For instance, the primary articles group would have food articles, non-food articles and minerals. Each of these sub-groups would have several individual commodities in them. The current WPI tracks prices of 435 commodities, of which 98 are primary articles, 19 fall in the fuel, power, light & lubricants group and 318 are in the manufactured products group. The WPI has been periodically revised from the time it was first constructed in the 1930s and for obvious reasons the weights have moved progressively in favour of manufactured products. The current index, which uses 1993-94 as its base year, has weights of 22.025 for primary articles, 14.226 for fuel etc and 63.749 for manufactured products.

How WPI is calculated?

WPI is calculated on a base year and WPI for the base year is assumed to be 100. For example, let’s assume the base year to be 1990. 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 2000, for a particular commodity, say wheat. Assume that the price of a kg of wheat in 1990 to be INR 8 and in 2000 to be INR 10, and say the weight age for the commodity in the index is 15%.

The WPI of wheat for the year 2000 is,

{(Price of Wheat in 2000 – Price of Wheat in 1990)/ Price of Wheat in 1990} x 100

i.e. {(10 - 8)/8} x 100 = 25

Since WPI for the base year is assumed as 100, WPI for 2000 will become {100 + (25 x 0.15)} = 103.75.

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 Inflation is calculated?

Using the WPI figures of two time zones, say, beginning and end of year, the inflation rate for the year can be calculated by applying the formula as:

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

For example, WPI on Jan 1st 2000 is 103.75 and WPI of Jan 1st 2001 is 108.15 then inflation rate for the year 2001 is,

{(108.15 – 103.75)/103.75} x 100 = 4.24% and we say the inflation rate for the year 2001 is 4.24%.

WPI figures are available every week, with a shortest possible time lag of two weeks, inflation for a particular week is calculated based on the above method using WPI of the given week (say 1^st week of 2001) and WPI of the week one year before (i.e. 1^st week of 2000). These rates are available not before the 3^rd week of 2001. This is how we get weekly inflation rates in India.

Why WPI and not CPI?

There is a serious debate going on, why India does not switch the calculation of inflation based on CPI, as the major countries in the world do so, and why are we still calculating it on WPI. The most important argument in the favor of this is, as CPI actually measures the increase in price that a consumer will ultimately have to pay for. It pointed out that WPI does not properly measure the exact price rise an end-consumer will experience because, as the name suggests, it is at the wholesale level.

Arguments in favor of WPI are, in India, there are four different types of CPI indices, and that makes switching over to the Index from WPI fairly 'risky and unwieldy.' The four CPI series are: CPI Industrial Workers; CPI Urban Non-Manual Employees; CPI Agricultural labourers; and CPI Rural labour. Secondly, the WPI is published on a weekly basis and the CPI, on a monthly basis. Thirdly, WPI has a broader coverage than the CPIs in terms of the number of commodities.