Thursday, December 1 2022

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What is Inflation? How is it measured?

Inflation is an indicator of how much money you have to spend to meet your needs relative to a benchmark. For example, suppose you have only two needs, food and clothing. You spend INR 80 on food and INR 20 on clothes in year 1. Next year prices went up and now you have to spend INR 84 and INR 26 on food and clothes respectively, to consume the same amount of these goods that you consumed last year. . As a result, the total expenditure for Year 2 increased to INR 110 from INR 100 in Year 1. Thus, the inflation in year 2 compared to year 1 is 10% because you had to spend 10% more in year 2 than in year 1 in order to maintain your level of consumption.

In real life, our expenses are not limited to food and clothing. Education, health, etc. are some of the other expenses we have to meet. Through the use of various surveys, government agencies construct a basket of goods and services. This basket indicates, on an average basis, which goods and services a consumer consumes in a year and in what proportion. Various baskets can be constructed keeping in mind different population groups and different purposes. Consumer price inflation (combined), i.e. CPI(C), is the most popular basket as it shows average consumer consumption across the country.

For the base year (Year 1 in the example of the 2nd paragraph), the total cost of the basket is always taken as 100. The cost of the basket will change over the years due to the variation in the prices of its goods and constituent services. The cost of the basket is called the index level.

The base year used for the CPI is 2012. Its composition is given below

The table can be interpreted as follows. An average consumer spent INR 45.86 out of INR 100 of expenditure on food and beverages in 2012. For the calculation of inflation in future years, it is assumed that the quantities and relative proportions of goods and services in the basket would remain the same. even for an average consumer in the years to come. Inflation at a given point is calculated as the % change in the level of the index relative to a benchmark.

How was the 7% CPI inflation rate in August 2022 calculated?

In August 2022, the value of the CPI index (combined) stood at 174.3, which means that to purchase the items mentioned in the table above in the same quantities as they were purchased in 2012, we are expected to spend INR 174.3 in August 2022 instead of the required INR 100. in 2012. Therefore, the inflation rate in August 2022 is 74.3% compared to the reference year 2012.

So what is the figure of 7% that is making the rounds in the media?

Well, in regular use, the inflation rate at any given time is calculated as the percentage change of the index level from the index level before 1 year instead of the index level at the base year. In August 2021, the value of the basket was 162.9. Therefore, the inflation rate in August 2022 was calculated as follows –

((Index Level Aug 2022 – Index Level Aug 2021)/Index Level Aug 2021)*100

and that gives us the number of 7%.

Interesting insight: The CPI is a weighted average rate of the components of the basket. But the inflation would be different for the different components of the basket. The CPI rate therefore has little meaning for an individual because their pattern of consumption may be very different from the pattern of the average consumer as indicated by the CPI basket. A person who has to travel a lot for work would experience an inflation rate much higher than the CPI rate because fuel prices have risen much more than the prices of other items. Again, a family with 3 children pursuing higher education would be much more affected by education inflation than inflation for other items. CPI rates can be useful for making macroeconomic policy decisions, but they have less impact on individuals. Therefore, instead of worrying about CPI inflation rates, individuals would be well served if they focused more on their own spending and how to control it.

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These articles are published as received – they have not been edited/verified by ThePrint.


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