In good times, when inflation is under control, price indices sound like some well-conducted symphony orchestra. But when times are really bad, the same indices sound like some irritating siren. An uncontrolled rise in prices, just like defective musical instruments, can convert melodies into unbearable noise. Our friend Johnny is well aware of the problem of inflation but he does not yet know how the rise and fall in prices is actually monitored. Today our friends are chatting about different price indices that we use to measure inflation.
Jinny : Hi, Joh01nny! Why are you staring at the sky?
Johnny: Whenever prices rise, I closely watch the sky. I want to keep a watch on their rise or fall.
Jinny: Why do you strain your neck when you can know about the rise and fall in prices by simply watching price indices?
Johnny: What kind of indices can tell me about price rise?
Jinny: Economists use the Wholesale Price Index (WPI), the Consumer Price Index (CPI) and the GDP deflator series for measuring inflation. Today, let’s focus only on the WPI and CPI. We shall talk about GDP deflator some other time. India uses the WPI for keeping a watch on inflation, whereas the US relies on the CPI. As the names of the indices suggest, the WPI captures the price of goods at the wholesale level. It keeps a watch on the price at which your shopkeeper procures goods. The CPI, on the other hand, captures the price of goods at the consumer level. It takes into account the price at which the consumer is able to purchase goods and services. In India, we have four CPI indices for four different groups: CPI for agricultural labourers (AL), rural labourers (RL), industrial workers (IW), and urban non-manual employees (UNME). The purpose of both the WPI and the CPI indices is same—they help us in finding out the rate at which prices are increasing.
Johnny: Really? Tell me, how are indices made?
Jinny: First of all, you need to select the base year from which you want to make your calculation. Second, you need to select the basket of goods and services that you want to keep in your index. Our WPI uses 1993-94 as the base year and keeps 435 goods in the basket. The base year of the index and the basket of goods keep on changing over a period of time to reflect the change in consumption.
The WPI does not include services and non-tradable commodities in the basket. That is because services can’t be traded like goods in the wholesale market. The CPI indices, on the other hand, include both goods and services.
We can divide the entire WPI basket into three groups having different weights: manufactured goods (63.75%), primary produces (22%) and fuel and energy (14.25%). Manufactured goods include food, textiles, chemicals, machinery tools, etc. Primary articles consist of unprocessed crops and fibres and livestock. The fuel group includes mineral oil, electricity and coal.
Once you know the weight of goods in the basket, you just need to know their wholesale price to find out how much it will cost to purchase them all in proportion to their weight.
Once you know the total cost of your basket in the base year, you can use the same for comparing the rise in prices over a period of time. The prices of some goods may rise over a period whereas prices of some goods may actually fall. For an easy comparison, the index makers use 100 as base value, which is proportionately related with the total value of goods in the basket. This base value will increase or decrease, over a period of time, in proportion to the rise and fall of the prices of goods in your basket. This helps us measure inflation.
Johnny: But, why do we rely on the WPI for measuring inflation when the real effect of price rise on consumers is captured by the CPI?
Jinny: The WPI is useful in measuring inflation because it is available on a weekly basis, with a shorter time lag of two weeks. It means that whatever WPI index you are seeing today has been calculated on the basis of data available two weeks ago.
The CPI indices, on the other hand, are available on a monthly basis after a much longer time lag. Each CPI index uses different baskets of goods and services which reflect the consumption pattern of different groups of consumers. Different indices may show different patterns of increase in prices. An urban non-manual labourer is more likely to be affected by an increase in house rent than a rural labourer. The presence of four different CPI numbers makes the assessment of inflation by this method difficult. This is the reason why we presently rely on the WPI for measuring inflation. Maybe, in future, with better design, we shall have an index which more closely captures our cost of living.
Johnny: I, too, hope so, Jinny. Maybe in future, there will be no need to stare at the sky.