Explain how a country can calculate an accurate rate of inflation.

In order to assess its position and decide on future economic policies, a country has to know the rate at which
the prices of commodities are changing. The economists do this by calculating the inflation rate, which is the
percentage increase in the prices of a bundle of commodities that a typical household in the economy buys
regularly. We will now go through the procedure of calculating inflation and understand the technicalities
regarding its integrity and accuracy.
In order for an accurate inflation rate to be calculated, prices of around 600-650 commodities should be
collected once a month by a government body such as the National Audit Office in the UK. To keep the prices
as accurate as possible, the prices should be checked again and again at the same date each month at a
variety of different outlets or locations. For example, a cup of coffee may have a very different price in a
coffee shop in Glasgow than a trendy caf in London.
A good number of prices that should be collected, if 600-650 goods are targeted, would be 100,000-105,000.
These prices should be then assigned weights to show the importance of the commodities. That is, coffee
would be assigned more weight when calculating inflation than shoe polish because the average individual
spends a greater proportion of his income on coffee than shoe polish.
When commencing the calculation of inflation, a base year is selected and given the value of 100, meaning
that prices are constant. This value is called the index, upon which the current year inflation rate would be
calculated. The weights are then multiplied by the index value i.e. 100 for each good to get the value of
weighted index. Their products are then totaled and are divided by the sum of weights assigned in the base
year. This will give us the Average Weighted Index of the previous year. This procedure will be repeated with
the current year values to find the Average Weighted Index of the current year. The base year Avg. Weighted
Index would be then deducted from the current year Avg. Weighted Index which will give us the inflation rate.
Despite the precautions taken, the inflation rate cannot be completely accurate owing to several problems.
Firstly, the individual spending pattern is different than the typical spending pattern used to calculate the
inflation rate. Some people smoke, some dont, so an increase in the price of cigarettes would result in
inflation for the smokers but would not affect the non-smokers. Similarly, there are good chances of
calculation errors and administrative hindrances which further decreases the accuracy of the inflation rate.
There is also a delay in updating the typical basket, which is in itself a major hurdle in finding out a true rate of
inflation.
However, this does not mean that we should not at all calculate inflation rate. We should, because we do
come to know an inaccurate rate of inflation instead of nothing at all, which will help a country immensely in
deciding on the economic policies and operating patterns. Ultimately making the country and its people better
off.

Additional Notes:

Hasan Raza 1/21/14