How is inflation calculated?

Summary

• Keeping a tab on inflation is of special importance to government bodies as it is a key factor influencing policy decisions.
• Consumer Price Index (CPI) is a measure of inflation that takes a weighted average of essential goods and services in an economy.
• The wholesale Price Index and Producer Price Index are also used to calculate inflation from the seller’s perspective.

Measuring inflation would seem like an easy task as inflation refers to the rate of change of prices. Typically, individuals try to gather inflation estimates by calculating the percentage in their household expenses over time. Many individuals take rising nominal incomes as an early sign of inflationary pressures kicking into the economy, keeping their real income at the same level.

However, economists and policymakers use slightly more detailed methods to analyse inflation. The indexes used to depict inflation in the economy are derived from the prices of goods and services, quite close to how individuals make inflation estimates. However, the inflation calculated through these indexes is a more accurate measure as it includes more goods and services.

Calculating inflation is an essential task for governments and for policymaking bodies as it is a crucial aspect around which many laws and policies are based. For households, knowing inflation levels helps them set their price expectations for the future.

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Inflation is best understood with the help of indexes. Here is a closer look at how such an index is calculated:

A Look at Consumer Price Index (CPI)

Consumer Price Index or CPI is perhaps the best-known index used to calculate inflation. CPI can simply be understood as the change in the prices of a basket of goods and services. In most countries, the statistical agency in charge of collecting national data is responsible for calculating inflation. For instance, in Australia, CPI is calculated by the Australian Bureau of Statistics (ABS) and is published every quarter.

In essence, CPI captures the price change of those goods and services which are essential for households and are used most extensively by them. The index is a weighted average of the chosen goods and services, meaning each item included in the index has a weight attached to it.

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The prices included in CPI are the retail prices, i.e., the prices at the last leg of the lifecycle of the product. This marks a distinction between CPI and other inflation indexes.

Here are some steps that the authority in charge follows while calculating CPI:

Data Collection: This is a macro level task as it involves collecting price information about thousands of goods and services that are used by households. Since the CPI is calculated on a national level, it must cover all aspects of the economy. These prices are then categorised into broad sectors.

Attaching weights: Each item included in the CPI calculation must be given weight because different commodities or services may not be equally valuable to a household. For instance, the price rise of an essential commodity like milk would have a greater impact on households compared to a price rise in infant food. This happens because not every household has a child to feed. However, milk is an essential commodity that every house needs.

Weights are attached to the included items in the calculation based on the proportion of income spent on buying those items. Thus, if 2% of the household income is spent in a quarter on sugar, then the weight attached to sugar in the CPI calculation would be 0.02. As smartphones became a necessity, households started spending more money on them, giving them a higher weightage in the calculation.

Calculation: Now, a weighted average is obtained of the basket of goods using the respective weights thus obtained. This means, price change is separately calculated for each item, which is then multiplied by the respective weight of the item and finally, an average is taken.

The formula for CPI is as follows:

Here, the base year is determined by the authority. It reflects a threshold point beyond which inflation is being calculated. For instance, in the United States, the Bureau of Labor Statistics (BLS) used the year 2017 as a base year while calculating CPI in 2014.

Calculation of Inflation

Method 1: inflation can simply be found out using the obtained CPI, simply by calculating the rate of change in it. Therefore,

Here T₁ = Base Year / Base Quarter

         T₂ = Given Year / Given Quarter

Another method of calculating Inflation through CPI

Method 2: Suppose an economy only consumes apples and oranges. Thus, these are the only two items included in the basket of goods used to find out inflation. Their prices in this quarter and last quarter are:

Suppose consumers have a bias towards apples, and they spend a greater amount of money on apples, precisely 60% of their income. So, the CPI weight for apple is 0.6.

This leaves 40% of their income for the consumption of oranges. So, the CPI weight for orange is 0.4.

Now using these CPI weights, one can find out the level of inflation over the quarter.

Thus, on average, prices have risen by 4.32% over the quarter.

Despite being widely used, CPI has certain limitations associated with it. These include: 

• Does not account for absolute price level: Since the index has been designed as such that it only incorporates price change, the actual price level is not factored into it. Thus, if the CPI of commodity A is higher than the other, then it does not mean that the former is more expensive. It simply indicates its price has risen more sharply.
• Substitution bias: The substitution bias is the inability of the index to account for changing consumption patterns. When consumers change from one product to another simply because the other is cheaper, this change is not reflected in the index.
• Changes in quality: The weights are given to the items based on what proportion of their income is spent on them. If one item starts coming in smaller packaging, then the consumer would have to buy more of that item, increasing its weight unjustifiably in the CPI.

Other Indexes

Some other indexes used to calculate inflation are the Wholesale Price Index (WPI) and Producer Price Index (PPI). The wholesale price index works much in the same way as CPI. However, the price level which is taken in the basket of goods is the wholesale price level, not the retail price level.

PPI measures changes from the point of view of the seller, unlike CPI. It includes various indexes which measure the change in the selling price obtained by domestic producers and intermediary goods and services.

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