Question

Discuss inflation and consumer price index. Please explain in detail. Thank you.

Answer 1

Inflation refers to the rise in the aggregate price level of almost all the goods and services of daily or common use, which includes food, clothing, housing, recreation, transport, consumer staples, etc. Inflation measures the average price increase in a basket of commodities and services which are included in the consumer basket over time. The opposite of inflation which is rare phenomenon means fall in the aggregate price level in the consumers basket which includes same items as above is termed as ‘deflation’. Inflation indicates overall decrease in the purchasing power of a consumer, as the consumer won’t be able to purchase the basket at previous price. Inflation causes a decrease in the unit of a country’s currency. We measure inflation in percentage.
When we have an inflation, the cost of living gets higher as well, which may lead in slowing of economic growth. But still a certain level of inflation is required in the economy to ensure that expenditure is promoted and hoarding money through savings is not motivated. As money will lose its value over time because of inflation, people will find it is important for them to invest the money which will ultimately be valuable to them. Investing ensures the overall economic growth of a country.
Inflation can be measured using indices one of index is Consumer Price Index (CPI) which measures increase in the overall increase in the price at retail level.
A CPI is a comprehensive measure which is used for estimation of increase in the price level in a basket of goods. We can calculate CPI by taking price for each item in the fixed basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living which will ultimately lead to inflation or deflation.
Method for Calculating Consumer Price Index includes the following steps:
1)Fixing the consumer’s market basket – Before calculating CPI we need to specify the commodities which are consumed by consumers of that particular region or country to get the exact view as the basket differs according to the place and way of living.
2)Calculating the consumer’s basket cost – Once the previous step of fixing the basket is done, the next step in calculating the Consumer Price Index is to find the current and previous prices of all goods and services which were included in our basket. This will allow us to calculate the price of the consumer basket at any particular point of time. The important thing to note here is that the consumer’s market basket should remains fixed, which means goods or services and their quantity is fixed in both period of time. Hence, we have variable price.
3)Computing the index – Next step is to actually calculate the Consumer Price Index for this we need to define a base year and the current year. The base year will serve as the benchmark against which current years are compared. The base year can be designed freely. In this we will multiply the initial quantity with current price and then divide it by intial quantity multiplied by base year price and then multiply the result with 100. This also known Laspyre’s Index number.
4)Computing the inflation rate – Lastly after calculating CPI we can use that to compute inflation rate.
This method of calculating CPI is also known as Aggregate Expenditure method.
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