17.1 Introduction
17.2.Definition of Inflation
17.5 Summary
17.6 Check your progress
17.1 Introduction:
Dear student, in an earlier lesson we studied trade cycles and their phases. In this lesson
you are going to learn the concept of inflation and how do we measure the inflation. We
know that a rise in price is generally called as inflation. But we do not aware about the
computational methods of inflation. It means that if there is inflation in an economy, how
much inflation is there and how will it compute, all these things are unknown aspects to
us. Therefore, the present lesson is devoted to understand clearly what is inflation and
how inflation is measured. What are the different methods which are available to
compute it. Since 1700 to 1930’s unemployment problem was the main concern of then
economists but during 1930’s unexpectedly inflation has become a problem of the same
intensity that of unemployment. Thus since 1930’s the problem of inflation attracted the
attention of economists and policy makers. So let us now concentrate on the concept of
inflation and its measurement in an economy.
There are many definitions of inflation. By inflation most people understand a sustained
and substantial rise in prices. For example:
Milton Friedman writes ”By inflation I shall mean a steady and sustained rise in
prices”
Prof Samuelson puts it as “Inflation occurs when the general level of prices and
costs is rising”.
Thorp and Quandt, opine that it is of great help to define inflation in terms of
obseravable, phenomenon and for his reason the process of rising prices should be
considered as inflation.
This type of definition of inflation is, however, beset with certain difficulties. The first is
that there may be price rises which are not inflationary. There may occur a crop-failure or
some other natural calamities like flood or earthquake. This will cause a sharp decline in
food supply as a result of which there would be some rise in prices to ration the reduced
supply. Or let us take another situation in which the economy is moving from depression
to a higher level of employment. There would certainly be some increase in prices due to
an increased demand for goods and services. These two cases of price rises cannot be
regarded as inflation because these are self-limiting and at the same time do not pose any
serious policy problem.
Keynes mentions the following four related terms while discussing the concept of
inflation:
Reflection: is a situation of rising prices, deliberately undertaken to relieve a depression.
With rising prices, employment, output and income also increase till the conomy reaches
the full employment ceiling.
Inflation: it occurs when prices rise after the stage of full employment is reached in the
economy.
Disinflation: when prices are falling due to anti-inflationary measures adopted by the
authorities, with no corresponding decline in the existing level of employment, output
and income, and result is disinflation.
On different grounds, economists have classified inflation into various types. A few
important categories are presented in the following:
a) War-time Infaltion
b) Post-War Infaltion
c) Peace-time Inflation
According to the Government’s reaction:
a) Open Inflation
b) Repressed Inflation
a) Credit Inflation
b) Deficit Inflation
c) Scarcity Inflation
d) Profit Inflation
e) Foreign trade Inflation
f) Tax Inflation
g) Cost or Wage Inflation
h) Demand Inflation
Inflation can be measured by following different methods, but there are certain
difficulties in measuring by using each one of the methods. Shall we choose a wholesale
price index or a consumer price index? The government of Japan relied on wholesale
price index to show that the rapid economic growth of 1960-62 was not inflationary,
while the opposition made use of consumer goods price index to show that the position
was reverse. A similar problem arises when we have to choose between a price index
which includes taxes and subsidies and the one which excludes taxes and subsidies.
The difficulty with the use of a price index for measuring inflation is that most price
indices do not take into account of changes in the quality of the product. There are many
instances in which the price of a particular good has increased with an improvement in its
quality. A new higher priced model of a particular model car will certainly yield better
service than an old one and thus an increase in its price cannot be called inflationary.
Above discussion reveals that there are two important methods in measurement of
inflation, they are : Consumer price Index and Whole sale Price Index. Let us now have
a glance at these methods.
The Consumer Price Index measures prices of a selection of goods and services
purchased by a consumer. The inflation rate is the percentage rate of change of a price
index over time. For instance, in January 2009, the Indian Consumer Price Index was
202.4, and in January 2010 it was 211.1. The formula for calculating the annual
percentage rate of inflation in the CPI over the course of 2009 is
211.1-202.4/202.4*100 = 4.28%
The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the
general level of prices for consumers rose by approximately four percent in 2009.
Whole sale price index measures average changes in prices received by domestic
producers for their output. This differs from the CPI in that price subsidization, profits,
and taxes may cause the amount received by the producer to differ from what the
consumer paid. There is also typically a delay between an increase in the Producer Price
Indices and any eventual increase in the Consumer Price Index. Producer price index
measures the pressure being put on producers by the costs of their raw materials. This
could be "passed on" to consumers, or it could be absorbed by profits, or offset by
increasing productivity.
17.3.3 Commodity price indices, which measure the price of a selection of commodities.
In the present, commodity price indices are weighted by the relative importance of the
components to the all in cost of an employee.
17.3.4 Core price indices: because food and oil prices can change quickly due to
changes in supply and demand conditions in the food and oil markets, it can be difficult
to detect the long run trend in price levels when those prices are included. Therefore most
statistical agencies also report a measure of 'core inflation', which removes the most
volatile components (such as food and oil) from a broad price index like the CPI. Because
core inflation is less affected by short run supply and demand conditions in specific
markets, central banks rely on it to better measure the inflationary impact of current
monetary policy.
The Consumer Price Index, for example, uses data collected by surveying households to
determine what proportion of the typical consumer's overall spending is spent on specific
goods and services, and weights the average prices of those items accordingly. Those
weighted average prices are combined to calculate the overall price. To better relate price
changes over time, indexes typically choose a "base year" price and assign it a value of
100. Index prices in subsequent years are then expressed in relation to the base year price.
Inflation measures are often modified over time, either for the relative weight of goods in
the basket, or in the way in which goods and services from the present are compared with
goods and services from the past. Over time adjustments are made to the type of goods
and services selected in order to reflect changes in the sorts of goods and services
purchased by 'typical consumers'.
When looking at inflation economic institutions may focus only on certain kinds of
prices, such as the core inflation index which is used by central banks to formulate
monetary policy.
Most inflation indices are calculated from weighted averages of selected price changes.
This necessarily introduces distortion, and can lead to legitimate disputes about what the
true inflation rate is. This problem can be overcome by including all available price
changes in the calculation, and then choosing the median value.
17.5 Summary
Inflation is commonly understood as a situation of substantial and rapid general increase
in the level of prices and consequent deterioration in the value of money over a period of
time. The behaviour of general prices is measured through price indices. The trend of
price reveals the course of inflation or deflation in the economy. A price rise which is
unforeseen and uncorrected is inflationary. Thus, inflation is statistically measured in
terms of percentage increase in the price index, as a rate per cent per unit of time-usually
a year or a month. Usually, the wholesale price index numbers are used to measure
inflation. Alternatively, the consumer price index or the cost of living index number can
be adopted in measuring the rate of inflation.
3. Core inflation, which maintains the most volatile components (such as food
and oil) from a broad price index like the CPI.
5. ”By inflation I shall mean a steady and sustained rise in prices” writes by
Crowther.