Consumer Price Index - Retail Inflation

INTRODUCTION 

Inflation or “ mehengaai “, one of the most discussed topics between all of us. It measures how much prices are increased on an average.Inflation is measured at producer level as well as consumer level.

CPI measures the retail inflation, which means that CPI measures average changes in prices of goods which a consumer is paying.

WPI ( wholesale price index) measures inflation at producer level which means that it measures average changes in prices of goods which a producer is paying.

In this article we will discuss various aspects about Consumer Price Index.

CALCULATION 

The calculation of consumer price index is divided into 5 steps.

1. Selection of Goods 

In the first step economists try to find out those goods which consumers are buying frequently. And accordingly they assign weightage to the goods. This weightage of goods is dependent on how frequently people in an economy are buying those goods. 

In this way the Economist tries to fix a set of goods with different weightage.

2. Prices of Selected Goods

After selecting goods, economists find out the prices of those goods in the market. However fixing prices and selection of goods is not an easy task, therefore actual data is required for selection of goods and fixing of prices.

3. Total Cost of Selected Goods

Once the goods are selected and prices are fixed the next step is to calculate the total cost of selected goods. This is done by multiplying the goods with their prices. The quantity of goods is determined by the weightage assigned to them.

4. CPI

After we are done with calculating the total cost of goods, we will calculate CPI.

CPI =

(total cost of selected goods in current year/ cost of selected goods in previous year) * 100

5. Inflation Rate

Now this is the last step where we will calculate the inflation rate. 

Inflation rate = { (CPI in year 2 - CPI in year 1) / CPI in year 1 } * 100

Till now we have discussed the calculation of CPI theoretically. Lets now understand the concept of CPI with a small example.

Example : let's assume there are 2 goods which we have selected for calculation of CPI. one is  Pizza & the other one is Burger.

Step 1 : The quantity of pizza (after assigning weightage) is 4 and burger is 2.

Step 2 :  The average  price of pizza is ₹250 and burger is ₹50 in current year and in previous year they were  ₹200 and  ₹30.

Step 3: Total cost of Selected goods

     In the present year: (4*250 + 2*50) = 1100

     In previous year : (4*200 + 2*30) = 860

Step 4 : CPI 

CPI = (Cost in present year / cost in previous year ) * 100

       = ( 1100 / 860 ) * 100

       = 127

Step 5 : Inflation Rate 

Just now we calculated the CPI for the current year. So suppose CPI in previous year was 115.

 Therefore inflation rate will be = {( CPI in year 2 - CPI in year 1 ) / CPI in year 1} * 100

= { ( 127 - 115 ) / 115 } * 100

= (12 / 115 ) * 100

=10.43 %

So in our example inflation growth rate is 10.43%, which is quite high !!!

India’s Basket of Goods

 Now you may be curious to know what is there in India’s basket of goods.

REAL & NOMINAL RATES

Nominal rates are those rates which are currently prevailing in the market.

Real rates are those rates which are inflation adjusted rates.

So, Real rates = Nominal rate - Inflation rate

For example you invest  ₹1000 in a fund which is offering a return of 10%. This is the nominal rate. And the inflation growth rate is 6%( per yr). 

So do you know how much are you really earning and how much your purchasing power will increase?

The answer is 4% because 6%is the inflation growth rate, which means that if you have not  invested  ₹1000 it will be worth ₹940. As prices in the economy would have increased by 6% per year on an average and the same thing which you were able to buy for rs 100 has now a worth of ₹106. So your purchasing power would have decreased by 6% if you have not invested in the fund. 

So 4% is the real rate of return which you will get after one year from this fund.

LIMITATIONS IN THE PROCESS OF CALCULATING CPI

1. Effect of Substitution of Goods

When the price of a good increases, people try to find a perfect substitute for it. Like if the price of apples increases, people may prefer to buy more oranges or pomegranate and less apples. So in this case the weight-age of apples and oranges in the selected basket of goods needs to be changed.

2. New Products

If a new product arrives in the market people will have more choices and they may prefer to buy it. For example mobile phones, when there were no mobile phones, they were not included in the basket of selected goods. But as we all know mobile phones have become a part of our life and daily needs. So now we have to include them in the basket of goods. Similarly after the  arrival of new products CPI may not depict actual inflation growth till they are not included in the basket.

3. Not Too Accurate

The inflation growth as depicted by CPI may not be equal to the inflation rate being bear by you. The simple reason behind this is that your needs and preference of buying goods may differ from other people and simply your basket of goods i.e. which you are buying as per your preference may differ by the goods selected for calculation of CPI.

Q/A 

Q. If rate of return on a FD is 7% and the inflation growth rate is 5%. 

1. What will be the increase in your purchasing power if you have invested ₹10,000 or dollars in this FD (in rs or dollars)?

2. What is the real rate of return ( in %) ?

 Give answers in the comment box.

Shaurya Gupta

Bcom(hons), University of Delhi

Financial Markets(hons), Yale University