Inflation

Everyday we talk about inflation, few months back this was the biggest hurdle for Finance minister. Inflation was rocketing high. Now we read that as inflation is easing Government can take measures to improve growth etc. But how exactly does it all work?

Let us start with defining inflation. Inflation is an increase in the prices of goods and services in an economy over a period of time. As everyone understands inflation increases means increase in the price and vice versa. Actually the concept is little deeper. We’ll understand this well when we’ll see how it is calculated.

There are two ways to calculate Price Indices:

1) Wholesale Price Index, WPI: WPI is the index that is used to measure the change in the average price level of ‘goods traded in wholesale market’. India has taken WPI as an indicator of the rate of inflation in the economy.

2) Consumer Price Index, CPI: CPI is a weighted average of prices of a specified set of goods and services ‘purchased by consumers’. It is a price index that tracks the prices of a specified set of consumer goods and services, providing a measure of inflation. CPI is the official measure of inflation in many countries such as the United States, the United Kingdom, Japan, France, Canada, Singapore and China.

India is the only major country that uses a wholesale index to measure inflation. The WPI has an All Commodities Index, which consists of three major groups – 

1) Primary Articles; 2) Fuel, Power, Light & Lubricants; and 3) 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.

This WPI tracks prices of 435 commodities, of which 98 are primary articles, 19 in the fuel, power, light & lubricants group and 318 are in the manufactured products group.

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.

Calculation of Inflation

Inflation is calculated point to point compared to last year. WPI figure is released every week. Base year us taken as 1993-94 where WPI is taken as 100. Current WPI is compared with WPI exactly 52 weeks back. These are the values of WPI of last year and this year:

Week No.	Date	WPI		Date	WPI
1	5/1/2008	217.6		6/1/2007	208.7
2	12/1/2008	217.8		13/01/2007	208.7
3	19/01/2008	218.2		20/01/2007	208.9
4	26/01/2008	219		27/01/2007	209
5	2/2/2008	218.8		3/2/2007	208.9
6	9/2/2008	219.4		10/2/2007	209
7	16/02/2008	220.4		17/02/2007	208.6
8	23/02/2008	220.9		24/02/2007	209
9	1/3/2008	222.3		3/3/2007	209.3
10	8/3/2008	225.7		10/3/2007	209.4
11	15/03/2008	226.4		17/03/2007	209.6
12	22/03/2008	226.6		24/03/2007	210.1
13	29/03/2008	226.7		31/03/2007	210.4
14	5/4/2008	227.8		7/4/2007	211.5
15	12/4/2008	228.2		14/04/2007	211.4
16	19/04/2008	228.9		21/04/2007	211.5
17	26/04/2008	229.1		28/04/2007	211.6
18	3/5/2008	230.5		5/5/2007	212
19	10/5/2008	230.6		12/5/2007	212.4
20	17/05/2008	230.8		19/05/2007	212.4
21	24/05/2008	231.2		26/05/2007	212.3
22	31/05/2008	232.3		39119	212.5
23	7/6/2008	236.5		9/6/2007	211.8
24	14/06/2008	236.9		16/06/2007	211.9
25	21/06/2008	237.7		23/06/2007	212.4
26	28/06/2008	238.4		30/06/2007	212.8
27	5/7/2008	239.3		7/7/2007	213.3
28	12/7/2008	239.5		14/07/2007	213.6
29	19/07/2008	240.5		21/07/2007	213.7
30	26/07/2008	240.7		28/07/2007	213.9
31	2/8/2008	241.4		4/8/2007	213.8
32	9/8/2008	241.1		11/8/2007	213.7
33	16/08/2008	241.1		18/08/2007	213.7
34	23/08/2008	241.2		25/08/2007	213.9
35	30/08/2008	241.4		39091	214.8
36	6/9/2008	241.7		8/9/2007	215
37	13/09/2008	241.7		15/09/2007	215
38	20/09/2008	241.3		22/09/2007	215.2
39	27/09/2008	241.3		29/09/2007	215.3
40	4/10/2008	239.6		6/10/2007	215
41	11/10/2008	238.8		13/10/2007	215
42	18/10/2008	238.3		20/10/2007	215.3
43	25/10/2008	238.5		27/10/2007	215.4
44	1/11/2008	235.5		3/11/2007	216.1
45	8/11/2008	235		10/11/2007	215.8
46	15/11/2008	235.1		17/11/2007	216
47	22/11/2008	233.7		24/11/2007	215.6
48	29/11/2008			39094	216.3
49	6/12/2008			8/12/2007	216.3
50	13/12/2008			15/12/2007	216.4
51	20/12/2008			22/12/2007	216.4
52	27/12/2008			29/12/2007	216.7

How inflation is calculated? For example we will get inflation for this week i.e. week number 47. Inflation_47 = (WPI_47_2008-WPI_47_2007)/WPI_47_2007 = (233.7-215.6)/215.6~8.4%. Important thing to note is inflation is always calculated compared so same week exactly a year back.

This is how inflation for the year looks:

Note that in May it showed a steep rise. This is mainly attributed to increasing crude price in that period. Fuel price were increased in period of June-July. This led to increase in transport cost leading to increasing in vegetable prices and other commodities.

Normally, high inflation is linked to higher money supply in the market. Think it this way, when there is high money supply this means purchasing power of people increases which leads to increase in prices. As we see, inflation is easing since September 2008. This gives Finance Ministry + RBI an opportunity to take steps for growth. Hence, they are more comfortable in decreasing interest and rates cut recently hence increasing the money supply in the system.