Inflation is everywhere in newspapers, media, economic books, and reports. Even if you are economic and business enthusiastic, then better knowledge of inflation, its causes, and measurement tools can help bolster you. In this regard, this article is an attempt to answer the following questions:
- What is Inflation?
- Are there Benefits of Measuring Inflation?
- What are the Causes of Inflation?
- How to measure inflation?
What is Inflation?
Inflation is the rise in prices of all goods and services over time. In other words, it is a continuous rise in the general price level in an economy. More precisely, inflation is a persistent and appreciable rise in the general level of prices. Every price rise is not inflation; for it to be inflation, there must be a minimum rate at which the price level must rise and a minimum period over which the price rise must continue.
When the prices of goods and services rise, it lowers the purchasing power of money and hurts individuals and households. There is also a time when the prices of all goods and services continually decline, which is deflation.
What is Underlying Inflation?
Underlying inflation refers to inflation that would occur under normal economic conditions. It excludes items with large price changes or highly volatile prices. The large swing in price may have come from supply disruption, infrequent changes in tax regulation, and other disturbances.
Causes of Inflation
There are so many causes of inflation. Some classify causes as internal vs external causes, while others demand-pull vs cost-push. In addition, there are plenty of theoretical explanations of the causes of inflation. If you want to know more, please read this article on the 7 most important theories of inflation.
Why measure inflation?
The importance of measuring inflation includes –
- To measure the direct impact of price rise on the life of citizens as the measure of the cost of living.
- To formulate monetary policy that targets price stability, whose measurement is provided by inflation.
How is Inflation Measured?
There are 4 types of most significant measurements of inflation. They are:
- Consumer Price Index, CPI
- Producer’s Price Index, PPI
- Implicit GDP Deflator
- Personal Consumption Expenditure, PCE
Consumer Price Index, CPI
It is the weighted average of the change in prices of a basket of goods and services a typical representative household consumes. The weight given to typical items in the basket is based on how much households spend on these items. After that, we measure the inflation of items compared to the previous period’s prices. The calculation of CPI takes place in some specific time intervals—yearly, quarterly, or monthly.
The actual measurement of CPI undergoes calculating inflation for each item in the basket and then taking the weighted average of individual inflation of items in that basket. For the sake of mathematical exposition, let’s look at the following formula for measuring inflation for a single item:
$$\text{Inflation} = \frac{$Price_{Period\ 2}\ – \ $Price_{Period\ 1}}{$Price_{Period\ 1}} * 100$$
After calculating the inflation for individual items, we take a weighted average of all inflations to derive the CPI. Note that the other term for CIP is “headline index”.
Problems of the Consumer Price Index
The consumer price index is so intensive that CPI virtually implies inflation. Therefore, the problems of measuring CPI are nearly the problems of measuring inflation. The following are the problems of measuring CPI accurately and reliably:
Not an Indicator of Price Level:
CPI measures price change in the economy but not the price level. This is so because it only measures price change from the previous period. Suppose, for example, the CPI of an apple is 220, and the CPI of a banana is 150. Then, CPI does not say that apples are more expensive than bananas; it only says that the price of apples has increased more than bananas. CPI measures the cost of purchasing a ‘shopping basket’.
Cost of Living Standard:
CPI is not a measure of the cost-of-living standard. Because the cost of living measures the total spending a household requires to maintain the given living standard or utility, CPI only measures price change, and it cannot measure household utility.
Substitution Bias:
Household spending patterns change rapidly as the relative prices of goods change. However, the CPI does not immediately update these spending patterns, creating a substitution bias.
Quality Bias:
Given that the quality of goods improves over time, the rise in price attributable to quality increase must be separated from any pure change in price. Not doing so will overestimate the CPI, thus introducing the quality bias.
Arrival of New Products:
New products that are available in the market are not immediately updated in the goods basket. The rise or fall in the prices of new products is not generally included for a few years.
Less Coverage:
CPI collects prices of items mostly from urban areas and it does not collect prices from rural or remote areas. Still, the CPI does not consider the difference in spending patterns between households. Some spend a lot more on one item than another, which introduces the bias in the weight given to a typical item in a basket. This will lower the power of CPI to measure the actual price change accurately.
Producer Price Index, PPI
PPI measures the average change in price received by producers of goods and services. It is measured as the weighted average price of goods and services at the first commercial transaction by the producer. In other words, PPI measures the average movement of price change of goods and services as they leave the producer. It excludes taxes, transport, and trade margins that the purchaser must pay.
As opposed to CPI, which is a measurement of price movement from the perspective of the purchaser, PPI is a measurement of price movement from the perspective of the seller. The purchasers’ and sellers’ prices can differ because of the indirect taxes, subsidies, transports, and trade margins.
The PPI indexes are published in various forms based on the classification of industry, product, and end-use. For this purpose, PPI calculation follows mainly three classification structures – Industry Classification, Commodity Classification (based on similarity or material composition), and Commodity-based Final Demand-Intermediate Demand (FD-ID) System.
Generally, the Bureau of Statistics of a country compiles PPI on an annual basis. The PPI is a very important statistic for economic and business decision-making, and monitoring inflation.
Implicit GDP Deflator
Deflation of current GDP by some constant will produce the real GDP or constant-price GDP. Therefore, the by-product of the deflation process is the implicit GDP deflator. The implicit tag is because the measurement of the GDP deflator is not as direct as the measurements of CPI and PPI. Instead, the GDP deflator is calculated using the following formula:
$$\text{GDP Deflator} = \frac{Current\ GDP}{Real\ GDP} * 100$$
Unlike CPI and PPI, the GDP deflator is not based on a fixed basket of goods and services, and it is not necessary to assign weight to items. The assignment of weight to items is automatic in the measurement of the DGP deflator as buyers vary their spending among different items.
DGP deflator measures more accurate pictures of the inflation in the economy than CPI. Thus, implicit DGP deflator is important for economists, while CPI is important for consumers.
Personal Consumption Expenditure, PCE
The alternative term for PCE is implicit price deflator. This alternative term is because PCE is also the by-product of the deflation process of current personal consumption expenditure. It is an index of price change of goods and services that are included in the personal expenditure component of Gross National Product, GNP. We get the PCE index by dividing current and real personal consumption expenditures.
It possesses characteristics similar to those of the implicit GDP deflator. Moreover, PCE is considered a more favorable tool for measuring inflation than CPI because it addresses some shortcomings of PCI, like substitution bias.