Inflation is the increase in the level of prices or alternatively it is a decrease in the value of money. To say that the prices have gone up means that a given number of dollar buys less or that the value of money goes down. An economy without inflation, using only barter, could have no inflation. The opposite of inflation is deflation, a decrease in the general level of prices or a rise in the value of money. ¹⁰

Inflation can also be defined as the pervasive and sustained rise in the aggregate level of prices measured by an index of the cost of various goods and services. Repetitive price increases erode the purchasing power of money and other financial assets with fixed values creating serious economic distortions and uncertainty. Inflation results when actual economic pressures and anticipation of future developments cause the demand for goods and services to exceed the supply available at existing prices or when available output is restricted by faltering productivity and marketplace constraints. ¹¹
 

4.2.b Measuring Inflation:

Inflation is measured as the annual percentage change in the value of a price index. A price index varies as the cost of purchasing a certain standard market basket of goods and services varies from the cost of purchasing the same market basket in the base year. A price index is calculated as the ratio of the current cost of a given market basket in the base year multiplied by 100.

Price Index =  Cost of market basket of products in current year                   * 100                ¹²
                        Cost of the same market baskets of products in the base year
 

A simple and common way of measuring inflation is by using the Consumer Price Index or CPI. ¹⁰

 The CPI is the price index most commonly used to measure the impact of changes in price on households. The index is based on a standard market basket of goods and services purchased by a typical urban family. ¹²

The Consumer Price Index affects all people because of the many ways it is used. The major uses are: ¹⁰

a) As an economic indicator: ¹³

The CPI is the most widely used measure of inflation and is sometimes viewed as indicator of the effectiveness of government economic policy. It provides information about price changes in the nation’s economy to government, business, labor, and other private citizens and is used by them as a guide to making economic decisions. ¹⁴

b) As a deflator: ¹³

The CPI and its components are used to adjust other economic series for price changes and to translate these series into inflation free dollars. An example of this is the use of CPI as a deflator of the value of consumer’s dollar to find its purchasing power. The purchasing power of the consumer’s dollar measures the changes in the value to the consumer of goods and services that a dollar will by at different dates. ¹⁴

c) As a means of adjusting dollar values ¹³

The CPI frequently is called a cost of living index but differs in important ways from a complete cost of living measure. A cost of living index would measure changes over time in the amount that consumers need to spend to reach a certain “utility level” or “standard of living.” Both CPI and cost of living index would reflect changes in the prices of goods and services that are directly purchased in the market place but a complete cost of living index would go beyond this to also take into account changes in other governmental or environmental factors that affect consumer’s well being. ¹⁴
 

4.2.c How is CPI measured?

The Consumer Price Index (CPI) is the ratio of the value of a basket of goods in the current year to the value of that same basket of goods in the earlier goods. It measures the average level of prices of the goods and services typically consumed by an urban American family. ¹⁵

The purchasing patterns of consumers were surveyed to determine a group of about 400 items or more, which buyers typically use. This group of items makes up a “market basket”. Each month a host of price surveyors checks on the prices of these items in cities across the country. These results are then used to compute what the market basket costs compared to what its cost in the base period.

To compute the price index, the cost of market basket in any period is divided by the cost of market basket in the base period is divided by the cost of market basket in the base period and the result is multiplied by 100. ¹⁰

An important use of price indexes is to measure what happens to the purchasing power of income. An alternate way to measure changes in purchasing power is to divide the person’s income in each year by the price index of that year and multiply by 100. This computation gives us real income. ¹⁶
 

4.2.d Problems measuring Inflation:

a)  The Consumer Price Index is based only on a small fraction of goods and services that   are available. If a person’s buying habits differ substantially from the market basket on which the index is based, that person may experience a different change in the cost of living than what the CPI shows.

b) Changes in the quality of products are difficult to incorporate into CPI. If a product becomes better with time and the price raises, the amount of change in price due to improved quality is not known. Changes in quality are rather common over long periods. Even though adjustments have been made for quality changes their very nature, such adjustments are in part subjective. ¹⁶

c) The CPI may not be applicable to all population groups. Also the CPI does not produce official estimates for the rate of inflation experienced by sub groups of the population.

d) The CPI cannot be used to measure differences in price levels or living costs between one place and another, it measures only time to time changes in each place. A higher index in one area does not mean prices are higher compared to a lower index area, It merely means prices have risen faster since their common reference period.

e )The CPI cannot be used as a measure of total change in living costs because these costs are beyond the definitional scope of the CPI and so are excluded. ¹³
 

4.2.e Other Price Indexes:

Since pure inflation is unlikely, it is useful to develop indexes for various sectors of the economy to more accurately chart changes in relative prices for a broad range of products.

Producer Price Index (PPI):

PPI measures movements in the price of a broad aggregate of products purchased by producers rather than consumers. This index is designed to measure inflation of prices for products used to produce other goods. Increase in the PPI is likely to fore shadow increase in the CPI. This is because increase in an average of producer prices will increase their unit costs of production and thus put upward pressure on the prices of final products.

Implicit GNP deflator:

This is an implicit index for all final products. It can be derived as the ratio of nominal GNP to real GNP. It is an index of the average of prices used to deflate nominal GNP. Nominal GNP measures aggregate production of final products at their current market prices while Real GNP measures the value of aggregate production of final products valued at base year prices.

Implicit GNP Deflator = Nominal GNP      *  100
                                          Real GNP

The aggregate of products used to compute the GNP deflator differs from that used to compute the CPI. Imported products are not part of GNP because they are produced in foreign nations rather than domestically. A change in the prices thereby will have no impact on the GNP deflator. However, change of imported products will affect the CPI. ¹²
 

4.2.f CPI – The best measure of inflation:

Inflation has been defined as the process of continuously rising prices of a continuously falling value of money. Various indexes have been devised to measure different aspects of inflation. The CPI measures inflation as experienced by customers in their day-to-day living expenses. The Producer Price Index (PPI) measures inflation at earlier stages of production and marketing processes. The Employment Cost Index (ECI) measures it in the labor market and the Gross Domestic Product Deflator (GDP- Deflator) measures combine the experience with inflation of governments, businesses and consumers. Finally, there are specialized measures such as measures of interest rates and measures of consumers and businesses executive’s inflation expectations.

The best measure of inflation for a given application depends upon the intended use of data. The CPI is generally the best measure for adjusting payments to consumers when the intent is to allow consumers to purchase at today’s price a market basket of goods and services equivalent to one that they could purchase in an early period.  ¹³