It seems that people often confuse the cause of inflation with the effect of inflation and unfortunately the dictionary isn't much help. As you can see in my article
What is the Real Definition of Inflation? the modern definition of inflation is"A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money..."
In other words according to this definition inflation is things getting more expensive.
But that is really the effect of inflation not inflation itself. The American Heritage® Dictionary of the English Language, Fourth Edition, Copyright © 2000 Published by Houghton Mifflin Company goes on to say:
...caused by an increase in available currency and credit beyond the proportion of available goods and services.
In other words, the common usage of the word inflation is the effect that people see. When they see prices in their local stores going up they call it inflation.
But what is being inflated? Obviously prices are being inflated. So this is actually "price inflation".
Price inflation is a result of "monetary inflation".
Or "monetary inflation" is the cause of "price inflation".
So what is "monetary inflation" and where does it come from?
"Monetary inflation" is basically the government figuratively cranking up the printing presses and increasing the money supply.
In the old days that was how we got inflation. The government would actually print more dollars. But today the government has much more advanced methods of increasing the money supply. Remember, "monetary inflation" is the "increase in the amount of currency in circulation".
But how do we define currency in circulation? Is it just the cash in our pockets? Or does it include the money in our checking accounts? How about our savings accounts? What about Money Market accounts, CD's, and time deposits?
But back to the question of the cause of inflation. Basically when the government increases the money supply faster than the quantity of goods increases we have inflation. Interestingly as the supply of goods increase the money supply has to increase or else prices actually go down.
Many people mistakenly believe that prices rise because businesses are "greedy". This is not the case in a free enterprise system. Because of competition the businesses that succeed are those that provide the highest quality goods for the lowest price. So a business can't just arbitrarily raise its prices anytime it wants to. If it does, before long all of its customers will be buying from someone else.
But if each dollar is worth less because the supply of dollars has increased, all business are forced to raise prices just to get the same value for their products.
How Do I Calculate the Inflation Rate?
The following article explains how to calculate the current inflation rate, if you know the Consumer Price Index. If you don't know it, you can find it
here.
If you don't care about the mechanics and just want the answer, use our
Inflation Calculator.
The Formula for Calculating Inflation
The formula for calculating the Inflation Rate using the Consumer Price Index is relatively simple. Every month the Bureau of Labor Statistics (BLS) surveys prices and generates the
current Consumer Price Index (CPI). Let us assume for the sake of simplicity that the index consists of one item and that one item cost $1.00 in 1984. The BLS published the index in 1984 at 100. If today that same item costs $1.85 the index would stand at 185.0
By looking at the above example, common sense would tell us that the index increased (it went from 100 to 185). The question is how much has it increased? To calculate the change we would take the second number (185) and subtract the first number (100). The result would be 85. So we know that since 1984 prices increased (Inflated) by 85 points.
What good does knowing that it moved 85 do? Not much. We still need a method of comparison.
Since we know the increase in the Consumer Price Index we still need to compare it to something, so we compare it to the price it started at (100). We do that by dividing the increase by the first price or 85/100. the result is (.85). This number is still not very useful so we convert it into a percent. To do that we multiply by 100 and add a % symbol.
So the result is an 85% increase in prices since 1984. That is interesting but (other than being the date of George Orwell's famous novel) to most people today 1984 is not particularly significant.
calculating a specific Inflation Rate
Normally, we want to know how much prices have increased since last year, or since we bought our house, or perhaps how much prices will increase by the time we retire or our kids go to college.
Fortunately, The method of calculating Inflation is the same, no matter what time period we desire. We just substitute a different value for the first one. So if we want to know how much prices have increased over the last 12 months (the commonly published inflation rate number) we would subtract last year's index from the current index and divide by last year's number and multiply the result by 100 and add a % sign.
The formula for calculating the Inflation Rate looks like this:
((B - A)/A)*100
So if exactly one year ago the Consumer Price Index was 178 and today the CPI is 185, then the calculations would look like this:
((185-178)/178)*100 or (7/178)*100 or 0.0393*100
which equals 3.93% inflation over the sample year. (Not Actual Inflation Rates). For more information you may check the
current Consumer Inflation Rate and
Historical Inflation Rates in table format. Or if you believe a picture is worth a thousand words you may prefer the
Annual Inflation Rate plotted in Chart format.
What happens if prices Go down?
If prices go down and we experienced Price Deflation then "A" would be larger than "B" and we would end up with a negative number. So if last year the Consumer Price Index (CPI) was 189 and this year the CPI is 185 then the formula would look like this:
((185-189)/189)*100 or (-4/189)*100 or-0.021*100
which equals negative 2.11% inflation over the sample year. Of course negative inflation is deflation.
Rising inflation was the most recent ticklish political issue that hit the Manmohan Singh government. But was inflation rising because of price rise in essential commodities? Or was it because of the
'erroneous method' of calculating inflation?
Some economists assert that India's method of calculating inflation is wrong as there are serious flaws in the methodologies used by the government.
Economists V Shunmugam and D G Prasad working with India's largest commodity bourse -- the Multi Commodity Exchange -- have come out with a research paper arguing that the government urgently needs to shift the method of calculating inflation.
Saying that there are serious flaws in the present method of calculating inflation, the paper India should adopt methodologies in developed economies.
So how does India calculate inflation? And how is it calculated in developed countries?
India uses the Wholesale Price Index (WPI) to calculate and then decide the inflation rate in the economy.
Most developed countries use the Consumer Price Index (CPI) to calculate inflation.
Wholesale Price Index (WPI)
WPI was first published in 1902, and was one of the more economic indicators available to policy makers until it was replaced by most developed countries by the Consumer Price Index in the 1970s.
WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions. It is also the price index which is available on a weekly basis with the shortest possible time lag only two weeks. The Indian government has taken WPI as an indicator of the rate of inflation in the economy.
Consumer Price Index (CPI)
CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation.
\CPI is a fixed quantity price index and considered by some a cost of living index. Under CPI, an index is scaled so that it is equal to 100 at a chosen point in time, so that all other values of the index are a percentage relative to this one.
Economists Shunmugam and Prasad say it is high time that India abandoned WPI and adopted CPI to calculate inflation.
India is the only major country that uses a wholesale index to measure inflation. Most countries use the CPI as a measure of inflation, as this actually measures the increase in price that a consumer will ultimately have to pay for.
"CPI is the official barometer of inflation in many countries such as the United States, the United Kingdom, Japan, France, Canada, Singapore and China. The governments there review the commodity basket of CPI every 4-5 years to factor in changes in consumption pattern," says their research paper.
It pointed out that WPI does not properly measure the exact price rise an end-consumer will experience because, as the same suggests, it is at the wholesale level.
The paper says the main problem with WPI calculation is that more than 100 out of the 435 commodities included in the Index have ceased to be important from the consumption point of view.
Take, for example, a commodity like coarse grains that go into making of livestock feed. This commodity is insignificant, but continues to be considered while measuring inflation.
India constituted the last WPI series of commodities in 1993-94; but has not updated it till now that economists argue the Index has lost relevance and can not be the barometer to calculate inflation.
Shunmugam says WPI is supposed to measure impact of prices on business. "But we use it to measure the impact on consumers. Many commodities not consumed by consumers get calculated in the index. And it does not factor in services which have assumed so much importance in the economy," he pointed out.
But why is India not switching over to the CPI meIs the government getting needlessly hysterical about inflation? Many people think it is okay to tolerate some inflation if, in return, it is possible to sustain higher growth rates. Nothing matters as much for peace, prosperity and poverty alleviation as high GDP growth, so I would always advocate any policy which delivers higher sustained GDP growth.
However, the link between inflation and growth is complex. High inflation does not give high growth. The growth miracles of Asia, where above 7% growth was sustained over a 25-year period, were not associated with high inflation. In fact, countries with high inflation have tended to have low growth.
In the business cycle, an acceleration of inflation can support a temporary acceleration of growth. In India, expected inflation has gone up from roughly 3% in 2004 to roughly 7% today--a rise of 4 percentage points. Interest rates have risen by less than 4 percentage points. As a consequence, real interest rates have actually gone down. Borrowing has become cheaper; we have a credit boom; and this is giving heightened GDP growth.
If inflation now stands still at 7%, this boost to GDP growth will fade away. Episodes where inflation went up are associated with a brief acceleration of GDP growth. A government can jolt an economy by raising the inflation rate. This heightened growth is not sustained. Conversely, achieving high sustained GDP growth is about fundamental issues of economic reform, and does not concomitantly require high inflation.
One of the great strengths of India is that the political system just does not accept high inflation. This is one area where politicians have been ahead of the intellectuals. Inflation of 3% is politically acceptable, and inflation above 5% sets off alarm bells.
The government that can jolt an economy by raising the inflation rate then has to go through the costly process of wringing out the inflation, to get back to 3%. Since there is no tradeoff between inflation and GDP growth, Parliament is right in demanding low inflation and high GDP growth.
Currently, in India, we go through boom-and-bust cycles; sometimes GDP growth rates are very high and sometimes GDP growth rates drop sharply. This boom-and-bust cycle is unpleasant for every household. There is a powerful international consensus that stabilising inflation reduces this boom-and-bust cycle of GDP growth.
The ideal combination, which has been achieved in all mature market economies, is one involving low inflation, which is also predictable and non-volatile. Low inflation volatility induces low volatility of GDP growth.
Low and predictable inflation also reduces the number of mistakes made by entrepreneurs in formulating investment plans. What India does not have is an institutional capacity for delivering predictable, non-volatile inflation of 3%.
In socialist India, the way to deal with an outbreak of inflation was to do government interference in commodity markets. A few commodities that "cause" inflation are identified, and the government swings into action: banning exports, giving out import licences, banning futures trading, sending the police to unearth "hoarding", etc.
This is deeply distortionary. Milk exports were banned, and milk prices fell. But why should milk farmers pay for a macroeconomic problem of inflation? The cost of bringing down inflation needs to be dispersed all across the economy.
If milk prices had been allowed to rise, then more labour and capital would shift from unproductive cereals to high-value milk production. India has the potential to be the world's biggest exporter of milk. But this requires a sophisticated web of producers, supply chain, exporters, factories, etc.
This sophisticated ecosystem will not flourish when the government meddles in the milk industry. A meddlesome government will go through the whiplash of doing an MSP one day because milk prices are low and banning exports another day because milk prices are high.
There is something profoundly wrong about a government that interferes in what can be imported and what can be exported. If the export of ball bearings were sometimes banned by the government, you can be sure there would be fewer factories to build ball bearings.
India is evolving from a socialist past into a mature market economy. How can predictable, non-volatile inflation of 3% be achieved? The recipe that has been developed worldwide is to devote the entire power of monetary policy to this one task. In India, the RBI has a complex mandate spanning over many contradictory roles. This has led to failures on inflation control.
In a mature market economy, a modern central bank watches expected inflation with great interest. Active trading takes place on the spot and derivatives markets, for both ordinary bonds and inflation-indexed bonds. Using these prices, a modern central bank is able to infer expected inflation.
When the short-term interest rate is raised or lowered, in order to respond to changes in expected inflation, there is a slow impact on the economy, possibly spread over two to three years. A modern central bank has the economic knowledge required to watch out for expected inflation deep in the future, and respond to it ahead of time, so as to deliver inflation that is on target.
In India's case, the RBI Act of 1934 predates modern monetary economics. In other countries, fundamental reforms have been undertaken in order to refashion monetary institutions in the light of modern knowledge. As an example, in the late 1990s, when Tony Blair and Gordon Brown won the election, they refashioned the Bank of England as a focused central bank which has three core values:
Independence: the Bank of England sets the short rate without involvement from the Ministry of Finance.
Transparency: the entire process through which interest rate setting is done is fully transparent so that the financial markets always know exactly what is being done and why.
Accountability: the Bank of England is accountable for hitting an inflation target. All tasks other than the inflation target were removed from the Bank of England.
The bad drafting of the RBI Act of 1934 is the ultimate cause of the distress of milk producers today. These linkages are not immediately visible, but they are very real. It is because India does not have a proper institutional foundation for monetary policy that we are reduced to distortionary mechanisms for inflation control.
Finance ministry officials point out that there are many intricate problems from shifting from WPI to CPI model.
First of all, they say, in India, there are four different types of CPI indices, and that makes switching over to the Index from WPI fairly 'risky and unwieldy.' The four CPI series are: CPI Industrial Workers; CPI Urban Non-Manual Employees; CPI Agricultural labourers; and CPI Rural labour.
Secondly, officials say the CPI cannot be used in India because there is too much of a lag in reporting CPI numbers. In fact, as of May 21, the latest CPI number reported is for March 2006.
The WPI is published on a weekly basis and the CPI, on a monthly basis.
And in India, inflation is calculated on a weekly basis.
Is the current inflation spiral primarily on account of agricultural shortages? Will the RBI's policy of raising interest rates kill the current expansion?
The pickup in headline inflation from about 4 per cent to over 6 per cent during the last 12 months, and the Reserve Bank of India's moves to rein it in, have sparked a vigorous debate in India. In our view, inflation is a problem - and the RBI has been correct in taking steps to bring it under control.
The debate has given rise to eight myths about inflation in India. It is useful to examine each of these myths so as to gain a clearer view of the issues - and the appropriate policy response.
It's all about food prices. Inflation stripped of food and energy, or other volatile components, is still rising. For example, between March 2006 and March 2007, year-on-year wholesale price index inflation excluding food and energy rose from 2 per cent to 7.9 per cent.
The pickup in inflation is all due to base effects from last year's low inflation. The notion is that depressed inflation in early 2006 exaggerates the rise in inflation during early 2007 on a year-on-year basis. But the three-month moving average of month-on-month, seasonally adjusted inflation has risen by about 3 percentage points over the past year - the same as year-on-year inflation.
Inflation will fall back to a normal range on its own. Leading indicators of inflation point one way: continued price pressures. Excess capacity has shrunk to a 14year low, according to the NCAER. In addition, there are signs of overheating in real estate and labour markets, with surveys showing the salaries of skilled workers rising by around 15 per cent annually.
Broad money growth has hardly slowed, still registering about 20 per cent year-on-year. With nominal GDP growing at about 14 per cent, this seems a classic case of too much money chasing too few goods - a recipe for inflation.
Fresh capacity will come onstream soon and alleviate constraints (or, what we really need are reforms to encourage supply). Investment and reforms are welcome - not just to combat inflation, but to generate growth and employment that can alleviate poverty and raise living standards. However, they take too long to come onstream to dampen inflation now. Indeed, inflation has risen despite double-digit growth in private fixed capital formation over 2002/03-2005/06, accompanied by an 8.5 percentage point rise in the ratio of overall investment to GDP.
Monetary tightening will kill the expansion. Keeping inflation under control, in fact, is key to sustaining the expansion. Waiting until inflation rises to higher levels will only make the job of stabilising prices harder. The international experience on this score is clear: When inflation expectations get entrenched at high levels, central banks have to tighten even more sharply to get inflation down.
Administrative measures are as good as - or better than - monetary tightening for controlling inflation. Some administrative measures can work against inflation control in the long run by discouraging supply. Banning exports and futures trading for selected commodities, for example, raises the cost of doing business and creates uncertainty about the regulatory environment. This can only discourage production, worsening supply constraints.
A stronger rupee does nothing to control inflation. A stronger rupee helps reduce inflation because it lowers the import prices of oil, other raw materials and capital goods and this, in turn, lowers the cost of production. It also reduces the prices of import-competing goods, like steel.
A related myth is that a strong rupee will kill the economy by hurting exporters. A stronger rupee does reduce the rupee value of export earnings - but it also reduces the cost of imported inputs, and to the extent that it dampens inflation, it limits the need for interest-rate hikes. Moreover, exporters are in a robust position now: as an earlier article in this newspaper pointed out, among 808 companies surveyed, net profits rose 67 percent in the October-December quarter.
Policy tightening will deny credit to small businesses and the common man, as well as hurt the poor. It is true that small businesses and the common man have only limited access to credit. This is a serious problem, but not one that can be solved through easy monetary policy.
The poor, meanwhile, not only have limited access to credit, but live on fixed incomes and have few or no assets to hedge against inflation - so that high inflation hurts them more than higher interest rates. Consistent with this idea, research by William Easterly and Stanley Fischer has shown that in a range of countries, higher inflation is associated with a lower share of national income accruing to the poor, a higher poverty rate, and a lower inflation-adjusted minimum wage.
In light of these realities, the RBI is right to have taken steps to rein in inflation. Compared with many other emerging countries, India has an admirable record of price stability. Maintaining this track record will pay benefits in terms of sustained growth with macroeconomic stability, and it will protect the most vulnerable Indians from the ravages of inflation.
Kalpana Kochhar is mission chief for India at the International Monetary Fund and Charles Kramer is a division chief responsible for the Indian economy.
Several theories are put forth by fraudulent experts who normally hide when there is bad time and emerge to explain growth , when it starts to happens. It is same way in stock markets when , the share markets boom, every TV channel and newspaper has suddenly several experts and investment advisors shouting to explain why this is happening. But when opposite happens they simply disappear and hide. The theories of trying to control Inflation, by RBI and GOI are outdated and foolish attempts and based on economics theory of regulating money markets and State intervention whichbhave little crdibility. These can only work in a disciplined market and stable matured economic conditions like in USA or UK. India is Far far away from it. A corrupt society, with severely unequal distribution of money, black money almost equal to official GDP generated every year, easy money flow form abroad, delicensing and speculations without any control, property prices soaring up without any logic, idiotic encouragemenmt ot retailing sector that has little to add value but contribued to fire in real estate markets, bullion prices are going up and share scrips have also gone up suddenly never seen in past except for brief period of harshad Mehta scam , but that was nothing as now. The government figures are fraudulent. I challenge GOI and all State governments to produce actual retail prices of 100 household items of daily consumption,semi durables and durable goods as on 2000 April and now ( except for electronic based items).The real inflation to consumer has been 15-20% per year range in most goods in last 5 years including drugs and property inflation 30-60% per year over last 5 years. It is now out of reach of common man whose salry has increased only at rate of 5% per year.High property rates result in panic and higher rents and cost of business which in turn fuel up prices. There is too much of liberalization with directors and senior executives of corporatuons fixing for themselves lacs of rupees of salaries per month or year in false euphoria created of India shining and in name of liberalisation of company laws.The money coming from abroad is mostly laundered money that is fueling property and bullion prices. Also share prices. Uncontrolled loot is going on in country with high speculation, land mafias busy , SEZs being set up with no future benefits, shamelesds and exhorbitant rate property auctions , etc with little or no control of government. The funny Institutes like RBI,SEBI etc and Our PM and FM who are pseudo experts ( in fact novices) in economics and Public administration are merely trying sketchy methods without any base and effectiveness just to show action knowing that what they are doing is an eternal run of the mill cut and edit exercise which is half hearted trial and error attempt with not much results. The situation in India has become pretty bad at cost of average consumer whose life has become hellish now. The promised dream shown when LPG was stared in 1991 has gone just the opposite. Instead of expansion of goods and quality improvements, and consequent price decreases, prices have increased severely and quality standards have gone down. Yes , a few lac people have become millionaires suddenly in few years. That is net gain of 15 years LPG and leadership of fraudulent economic experts like ManMohan Singh and Chidambram. The fall of congress is certain as this party no longer deserves to exist as it has lost relevance with most of its leaders boneless, corrupt and dividing society centered around one family projecting it as opoor substitute for Queen of Enmgland and a mascot of virtues and capabilty , in attempt to woo voters forgetting that their competitive parties will do the same quickly. Indian scenario looks pretty bad. It is actually shameful that after 60 years of independence , we have so high price rise rate, out of proportion real estate prices, rampant corruption, virtually non functioning judiciary,corrupt police organisations and general state of affairs which we can call laissez faire, safely. RBI will have to learn some new lessons and stop unnecessarily try to play with money markets as nothing is going to happen with 1% CRR or interest up or down,.In fact Indian governments are suffering from illusion that Government has duty to run business and manipulate markets. What government has to do is ban exports of fruit vegetable and cereals, release at least 10 million sq meters of land in all cities and metros in next 6 months, stop foolish auctioning of commercial sites, stop foolish SEZ policy that will be mere wastage of resources and will uproot farmers without an y long term benefits but will create social problems and see that Indian manufacturing sectors speeds up and goes higher than China. There should be control on salaries given to public servants and Private sector as this loot ultimately comes from pocket of consumer and tax payers and bound to create inflation as easy money is spent easily. Will our planners and senior bureaucrats try to understand above scenario and mechanism and take action before a civil war like situation emerges in the country?The inequality is actually increasing in all terms including earning power. This will rock the society soon.
