Inflation-Meaning and Measurement
Inflation is a continuous rise in the general price level of goods and services in an economy over a given time. The prices of most goods and services in the economy are on the increase in a period of inflation. One of the macroeconomic objectives of the government is to keep inflation under control because it leads to a fall in the value or purchasing power of money. Money loses value continuously in a period of inflation because the amount of goods that can be purchased with each unit of money decreases. An increase in the prices of products will lead to a fall in its purchasing power while a fall in prices will increase the value of money. This means that there is an inverse relationship between inflation and the value of money.
The cost of living is rising when the inflation rate is rising. The cost of living is a measure of what people spend on goods and services. The cost of living increases during inflation because people spend more on different products during inflation.
Disinflation and deflation
A reduction in the rate of inflation is referred to as disinflation. For example, if the inflation rate in a country decreases from 10% to 8%, average prices are still rising, albeit at a slower rate. The general price level is increasing at a slower pace than before. However, deflation occurs when the inflation rate is negative. That is to say, most prices are falling and the general price level is on the decline when an economy experiences deflation.
How is inflation rate calculated?
The rate of inflation is the percentage rise in the prices of goods and services bought by households over a period of time. It is usually made public every month and it shows the percentage rise over the previous twelve months. A very high inflation rate, say above 50%, is known as hyperinflation; hyperinflation makes money almost worthless. And people lose confidence in money as a medium of exchange and may resort to other means of exchange such as the barter system or the use of a more stable foreign currency such as a dollar. A low rate of inflation, say 2%, is known as creeping inflation.
Inflation can be measured through the Consumer Price Index (CPI) or Retail Price Index (RPI). The two methods of determining inflation use similar procedures but the products they cover are not exactly the same. CPI is a number that tracks changes in the average prices of a selected sample of goods and services consumers buy over time.
The steps involved in measuring inflation are explained below.
(1) Select a base year
A year is chosen as the base year or reference year. It is compared with other years to ascertain the price change. And it is given an index of 100. If the CPI in a subsequent year is 110, it means inflation is 10% (110-100).
(2) A sample of products is selected
A sample of products that consumers normally buy is selected. This should be representative of what an average household buys, e.g. housing, transport, food, health, insurance, alcohol and tobacco.
The CPI is not a simple average because it is usually weighted by the proportion of total expenditure spent on each good or service. A survey is carried out to determine how an average family spends its money on each item. The weight assigned to each product shows its importance; for example, a bigger weight means the item accounts for a bigger proportion of the consumers’ spending.
(4) Prices are monitored
The prices of a range of products are monitored and collected on a regular basis and the average price is calculated for each product category. This is to ascertain the price change between the base year and the subsequent year.
(5) Multiply the weights by the price changes
Weight and price change for each product category are multiplied. The price change for each category is also known as price inflation for each category and it may be obtained by computing an index number using the formula below:
Current year price
—————————— X 100
Base year price
The price inflation/change for each category is the figure obtained from using the above formula minus 100 (index number for base year).
(6) Addition of weighted prices
The results of the multiplication of weight and price change for all the categories are totalled to determine the inflation rate. The new CPI is the inflation rate plus the base year index. For example, if the inflation rate is 5%, the new CPI is 105 (100+5). This means prices have risen by 5% over the base year. But if inflation rate is to be calculated between two periods that exclude the base year, a percentage change in CPI between the two periods is calculated.
A numerical example on calculation of inflation rate
|Product category||Average prices||Weight|
|Base year||Year 1||Base year||Year 1|
|Alcohol & tobacco||$10||$15||70||50|
Calculate the inflation rate in year 1.
|Product category||Weight||Percentage of total spending||Price inflation||Weight x price inflation|
|Alcohol & tobacco||50||5%||50%||2.5%|
Percentage of total spending on food = 400/1,000 x 100 = 40%
Price inflation for food
Price index for food 50/40 x 100 = 125
Price inflation for food = 125 -100 = 25%
Weight x price inflation (food) = 0.40 x 25% = 10%
Limitations of the Consumer Price Index
Inflation cannot be measured accurately due to the following reasons:
It does not consider change in quality
Producers, in response to changing consumer wants, may add additional features to their products. If they raise prices due to improvements in product quality, inflation rate will be be overstated as there is actually no inflation in this case. It is often difficult to make adjustment for the impact of quality improvements on the price of products. So quality is entirely ignored or not fully accounted for.
The sample may be unrepresentative
A sample of goods and services that a typical household buys is selected. This may not really reflect the spending pattern of the people in a country. What people buy is determined by taste, income level, gender, family circumstance and age. Some items may not be applicable to some households. For example, not everyone owns a car and car-related expenses are not incurred by every household; its inclusion in the CPI is misleading.
Importance of each product category differs
The relative importance of different products is manifested in the weights assigned to them. The weights used in CPI calculation may be wrong due to the fact that the importance attached to each product by different households differs. A weight of 50%, for instance, for food means that 50% of the expenditure of an average family is spent on food. This may be appropriate for low-income families but inappropriate for families with high incomes. This is because low-income households tend to spend a greater proportion of their incomes of food while high-income earners spend a smaller percentage of their incomes on food. But there are certain things that high income earners spend more on, e.g. household products and recreation.
New products are not quickly included
The products included in the calculation of inflation are reviewed from time to time. But it takes time for new products to be considered. New and popular products are not included immediately, thereby making inflation measurement inaccurate. Also, there may be change in consumer taste or availability of cheaper alternative products during the period. This not usually captured in the inflation calculation in the period. Information on what consumers buy is not readily available.
Data collection error
Surveys are carried out to determine what people buy and how their incomes are spent on different products. There may be thousands of items involved. Sample selection may be prone to error leading to the selection of items that do represent what the whole population spends on. In addition, collection of data, such as prices, is susceptible to errors and omissions.