Inflation: Definition, WPI, CPI, Measurement and Causes

What is inflation? What are the problems associated with it? How to measure inflation rates? What are the types? Read further to know more.

Inflation is defined as a situation where there is a sustained, unchecked increase in the general price level and a fall in the purchasing power of money. Hence, it is a condition of price rise.

The reason for price rise can be classified under two main heads : (1) Increase in demand and (2) Reduced supply.

Inflation explained with an example

Suppose for Rs.100, last week you bought 5 Kg. of rice. This means that the cost of 1 kg of rice was Rs. 20. This week when you approached the same shopkeeper and paid Rs.100 to get rice, he gave only 4 Kg of rice. He also explained that the price of rice has increased, and now it is Rs.25 per Kg.

This example clearly explains the fall in the purchasing power of money. For Rs. 100 you could get 5 Kg of rice before, but now only 4 Kg. So purchasing power of money was reduced. This is inflation.

And let’s calculate the rate (percentage). If the price of rice, which was Rs.20 per Kg increased to Rs.25, this corresponds to Rs.5 increase on Rs.20, ie. a 25% increase. So the inflation rate is 25%, which is a very high rate.

Inflation Rates in India

There are different indices in India like Wholesale Price Index(WPI), Consumer Price Index(CPI), etc. which measure inflation rates in India. But what we generally find in headlines is the rate in India is a rate based on WPI. In the last 50 years, the WPI-based rate shows an average inflation rate of around 7-8%.

The highest inflation rate observed in India was 34.68 Percent in September of 1974. The lowest rate touched was -11.31 Percent in May of 1976 ( a case of deflation).

How to measure the Inflation rate?

Unchecked inflation can ruin the whole economy. There are many examples from African and South American economies which got shattered by the high rates. But who measures the inflation rate in India? And what are the types of Inflation indices in India? Let’s study each of them.

Inflation can be measured at three levels – producer, wholesaler, and retailer (consumer). Prices generally rise at each level till the commodity finally reaches the hand of the consumer.

Inflation at the Producer Level

As of now in India, there is no index to measure inflation at the producer level. A Producer Price Index (PPI) has been proposed, but so far this type of inflation calculation has not started in India.

Inflation at Wholesale Level

This is the most popular rate calculation methodology in India. The index used to calculate wholesale inflation is known as Wholesale Price Index (WPI). This inflation rate is often known as headline inflation. WPI is released by the Ministry of Commerce and Industry.

Though RBI used WPI for most of its policy decisions before 2014. However, the WPI-based inflation calculation was not false proof.  WPI shows the combined price of a commodity basket comprising 676 items. But WPI does not include services, and it neither reflects the bottlenecks between producer and wholesaler nor between wholesaler and retailer (consumer).

Hence in 2014, as part of the reforms initiated by RBI governor Raghu Ram Rajan, RBI shifted to CPI for policy decisions.

Inflation at Retail Level (Consumer Level)

The consumer often directly buys from the retailer. So the inflation experienced at retail shops is the actual reflection of the price rise in the country. It also shows the cost of living better.

In India, the index that shows the rate at the retail level is known as the Consumer Price Index (CPI). CPI is based on 260 commodities but includes certain services too. There were four Consumer Price Indices covering different socio-economic groups in the economy.

These four indices were the Consumer Price Index for Industrial Workers (CPI-IW); the Consumer Price Index for Agricultural Labourers (CPI-AL); the Consumer Price Index for Rural Labourers (CPI-RL) and the Consumer Price Index for Urban Non-Manual Employees (CPI-UNME).

CPI is now using a new series on the base 2010=100 for all India and States/UTs separately for rural, urban, and combined. The Central Statistics Office (CSO), Ministry of Statistics and Program Implementation releases Consumer Price Indices (CPI). CPI is based on retail prices and this index is used to calculate the Dearness Allowance (DA) for government employees.

Headline Inflation vs Core Inflation

Now let’s focus on two important terms Headline and Core Inflation.

Headline Inflation

It is the measure of total inflation within an economy. It includes price rises in food, fuel, and all other commodities.

The rate expressed in Wholesale Price Index (WPI) usually denotes the headline inflation. Though Consumer Price Index (CPI) values are often higher, WPI values traditionally make headlines.

Core Inflation (Underline or Non-food Inflation)

It is also a term used to denote the extent of inflation in an economy. But it does not consider the inflation in food and fuel. This is a concept derived from headline inflation. There is no index for direct measurement of core inflation and now it is measured by excluding food and fuel items from Wholesale Price Index (WPI) or Consumer Price Index (CPI).

Also read: Household Consumption Expenditure Survey (HCES)

Causes of Inflation

There can be two sets of factors that can cause inflation in an economy. They are Demand Pull and Cost-Push.

Demand-Pull Factors

1. Rise in population.
2. Black money.
3. Rise in income.
4. Excessive government expenditure.

Cost-Push Factors

1. Infrastructure bottlenecks lead rise in production and distribution costs.
2. Rise in Minimum Support Price (MSP).
3. Rise in international prices.
4. Hoarding and black marketing.
5. Rise in indirect taxes.

What measures can be taken?

Both the government and central bank (Reserve Bank) try to tackle inflation with their policies which are known as Fiscal and Monetary Policies respectively.

Fiscal policies correspond to tax-related measures taken by the government to control inflation (money supply). RBI through its various monetary policies limits the money supply by altering rates like CRR, Repo, Reverse Repo, etc.

Administrative measures taken by the government like the strengthening of the Public Distribution System also play a crucial role in curbing inflation.

Is inflation always bad for the economy?

Though high rates are not good for the economy, mild inflation, say under 3%, may turn, at times, useful for the economy. As we hinted in the beginning, inflation can occur because of high demand too. High demand for scarce resources will automatically increase prices.

But demand for a commodity is a good sign from the industry perspective. Industries now will try to produce more commodities to reap the benefit of high prices and demand. More production will trigger GDP growth.

Global inflation is calculated by measuring the average price changes of a basket of goods and services across multiple countries. The process involves comparing the current prices of the selected items with their prices in a base year. The most common method used to calculate inflation is the Consumer Price Index (CPI), which tracks the changes in prices of goods and services consumed by households.

Also read Dearness Allowance: Meaning and Types; Inflation Indexed Bonds