What is Inflation and Consumer Price Index (CPI) ?

 "Inflation is always and everywhere a monetary phenomenon" -  Milton Friedman             

The inflation rate is the percentage change in the price level from the previous period.

Today, if you want to buy an ice-cream cone, you need at least a couple of Rupees, but that has not always been the case. In the 1960s, my grandmother ran a sweet shop in Jahazpur, Rajasthan, where she sold ice-cream cones in two sizes. A cone with a small scoop of ice cream cost 25 paise. Hungry customers could buy a large scoop for a 50 paise. You may not be surprised at the increase in the price of ice cream. In most modern economies, most prices tend to rise over time. This increase in the overall level of prices is called inflation.

    

The Level of Prices and the Value of Money :-

Suppose we observe that over some period of time the price of an ice-cream cone rises from a 50 paise  to a 2 or 5 rupee coin . What conclusion should we draw from the fact that people are willing to give up so much more money in exchange for a cone? It is possible that people have come to enjoy ice cream more (perhaps because some chemist has developed a miraculous new flavor). But that is probably not the case. It is more likely that people’s enjoyment of ice cream has stayed roughly the same and that, over time, the money used to buy ice cream has become less valuable. Indeed, the first insight about inflation is that it is more about the value of money than about the value of goods.

Consumer Price Index

The CPI is used to monitor changes in the cost of living over time. When the CPI rises, the typical family has to spend more money to maintain the same standard of living. Economists use the term inflation to describe a situation in which the economy’s overall price level is rising. 

CPI in India is constructed for different segments of the population. There are five different measures of CPI: 

• CPI/Industrial Workers (CPI-IW). 

• CPI/Agricultural Labourers (CPI-AL). 

• CPI/Rural Labourers (CPI-RL). 

• CPI/Urban Non-Manual Employees (CPIUNME). 

• CPI-Combined (CPI-C). 

The first four measures are segment specific measures of CPI. Out of these, the first three are compiled by the Labour Bureau, Shimla whereas CPI-UNME is compiled by the CSO based at New Delhi.

How the CPI Is Calculated 

 1. Fix the basket. Determine which prices are most important to the typical consumer. If the typical consumer buys more Burger than Pizzas, then the price of Burger is more important than the price of Pizzas and, therefore, should be given greater weight in measuring the cost of living. The CSO sets these weights by surveying consumers to find the basket of goods and services bought by the typical consumer. 

2. Find the prices. Find the prices of each of the goods and services in the basket at each point in time. 

3. Compute the basket’s cost. Use the data on prices to calculate the cost of the basket of goods and services at different times. 

4. Choose a base year and compute the index. Designate one year as the base year, the benchmark against which other years are to be compared. (The choice of base year is arbitrary. The index is used to measure percentage changes in the cost of living, and these changes are the same regardless of the choice of base year.) Once the base year is chosen, the index is calculated as follows:

That is, the price of the basket of goods and services in each year is divided by the price of the basket in the base year, and this ratio is then multiplied by 100. The resulting number is the CPI. 

       

                                                                                                                              - Rohit Meena