Overview

1. How the Price Indexes (WPI or CPI) are

constructed.
2. Calculating WPI & CPI and the Inflation
Rate.
3. Problems in measuring the cost of
living index.
4. Correcting economic variables for the
effects of inflation.
 Consumer Price Index(CPI) Based on
the purchases of an Industrial worker/
Agri. Laborer
Wholesale Price Index (WPI) Based on
Producers prices on a chosen bundle of
commodities
GDP Deflator-Ratio of Nominal GDP and
Real GDP

Three Measures Of General

Price Level
Measuring the Cost of Living
1. To determine the cost of living index,
Ministry of Industry & Ministry of Labour
first identifies a market basket of goods
and services the typical consumer buys.
2. Ministry of Labour surveys consumers to
determine what they buy (commodity
basket) and, annually, the overall cost of
the goods and services they buy - CPI.
Measuring the Cost of Living
1. TheConsumer Price Index (CPI) is used to
monitor changes in the cost of living (i.e.
the selected market basket) over time.
When the CPI rises, the typical family has to
spend more rupees to maintain the same
standard of living.

2. The goal of the CPI is to measure changes

in the cost of living. It reports the
movement of prices not in rupee amounts,
but with an index number.
Whats in the CPIs Basket?
Hypothetical Example

Clothing Alcohol
Household
7.0% 5.0% Health
10.0% 4.0%
Recreation
10.0%

Shelter
28.0%
Food
18.0%
Transportation
18.0%
What is an Index Number?
An index number expresses
the value of some entity
(such as price or quantity)
at a given period of time in
absolute number form but
related to a base period set
Irving Fisher (1867-1947)
arbitrarily to 100.
Overview
1. how the Consumer Price Index (CPI) is
constructed.
2. Calculating Price Index and the
Inflation Rate.
3. Problems in measuring the cost of
living.
4. Correcting economic variables for the
effects of inflation.
THE CPI -- A SIMPLE EXAMPLE

Suppose that in 2010 all you bought was

coffee and rice.
Coffee was Rs 10.00 per cup and you
bought 365 cups.
Rice was Rs 30.00 per Kg and you
bought 50 kg.
THE CPI -- A SIMPLE EXAMPLE

In this example, we can treat 2014 as the

base period of reference year.
The CPI in 2015 would answer the
question How much would your total
spending change (relative to 2014) if
you bought the same quantity of coffee
and rice in 2015 as in 2014?
THE CPI -- A SIMPLE EXAMPLE

Suppose
- Price of a cup of coffee remains the same
in 2015 as in 2014 (Rs 10 per cup), but
Rice rise to Rs 40.00 per Kg.
- Whats the value of the CPI in 2011?
 THE CPI -- A SIMPLE EXAMPLE

- Total spending in 2014:

- 365 cups of coffee@ Rs10 = Rs 3650

- 50 kg of rice @ Rs 30 = Rs 1500
Total Rs 5150
 THE CPI -- A SIMPLE EXAMPLE

- Total spending in 2015

(if you buy the same stuff):

- 365 cups of coffee @ Rs10 = Rs 3650

- 50 kgs of rice @Rs 40 = Rs 2000
Total Rs 5650
 THE CPI -- A SIMPLE EXAMPLE

The CPI in 2015 = 5650/5150*100

= 109.7

Suppose the Cost rises to Rs. 6000 in 2016

The CPI in 2016 =
6000/5150*100
= 116.5
Calculating the Consumer Price
Index and the Inflation Rate
1. Determine what goods are most important to
the typical consumer: Fix the Basket
2. Find the prices of each of the goods and
services in the basket for each point in time:
Find the Prices
3. Use the data on prices to calculate the cost of
the basket of goods and services at different
times: Compute the Baskets Cost
4. Designate one year as the Base Year, which
is the benchmark for yearly comparison.
Calculating the CPI & the Inflation Rate
5. The final step includes using the CPI to calculate the
Inflation Rate, which is:
the percentage change in the price index from the
preceding period

6. Another Example for practice:

Base Year is 2010
Bundle of goods in 2009 = Rs1,200
The same bundle in 2010 cost = Rs1,236
CPI = (1,236 1,200) X 100 = 103
Prices between 2009 & 2010 increased by 3%
Wholesale Price Index
Wholesale price index (1993/4 base) much
more commodities:
Commodity Group # share

- Primary commodities 98 22.025%

- Fuel Power Lubrcants 19 14.226%
- Manufacturing 318 63.74%
- Total 435 commodities

http://www.eaindustry.nic.in/home.asp Source: Ministry of Industry

http://www.eaindustry.nic.in/experimental_sp_inde
Wholesale Price Index

The previous series with base 1981-82 covered a basket of 447

commodities drawn from 3 distinct sub-sectors namely, (i) primary
sector which include food articles and raw materials (mostly agro
non-food articles and minerals);
(ii) fuel/ power sector which includes coal, petroleum products and
electricity; and
(iii) manufactured sector which includes food products, beverages,
tobacco, textiles, wood, paper, leather, rubber and plastic, chemicals,
non-metallic minerals, basic metals, machinery, transport
equipments and other miscellaneous manufactured products.

The series is compiled, constructed and reported on a weekly basis.

Price Index & Inflation
The movements in retail prices are monitored in respect of 4
different segments of the population based on their location &
consumption behaviour - 4 distinct series of Consumer Price Index
Numbers:
(1) Consumer Price Index for Industrial Workers, CPI-IW, with base
1982; (covers 260 commodities)
(2) Consumer Price Index for Urban Non-Manual Employees, CPI-
UNME, base 1984-85; (covers 180 cdties)
(3) Consumer Price Index for Agricultural Labourers, CPI-AL, with
base 1986-87; (covers 180 commodities) and
(4) Consumer Price Index for Rural Labourers, CPI-RL, with base
1986-87 (covers 180 commodities). The CPI-RL was introduced in
November 1995.
 Price Index & Inflation
The existing WPI series with base 1993-94,
1999-2000, 2004-5 has been reviewed by a
Working Group. Each Group has suggested a
new base year and incorporated the impact of
structural changes in the economy and the
consequent changes in the relative importance
of the commodities constituting the basket.
Inflation: A Formal Definition
Pt - Pt -1
p t = x 100
Pt -1
This definition represents the statistic that is
reported when we hear stories about the rate of
inflation in the press, or on the news.

This definition is an ex post measure of inflation: It tells us how prices

changed between yesterday and today.
-10
-5
0
5
10
15
20
25
30
1971-72
1972-73
1973-74
1974-75
1975-76
1976-77
1977-78
1978-79
1979-80
1980-81
1981-82
1982-83
1983-84
1984-85
1985-86
1986-87
1987-88
1988-89
1989-90
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
Vs CPI

1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
WPI

2005-06
2006-07
2007-08
Inflation Rate - WPI

2008-09
2009-10
2010-11
2011-12
CPI_IW

2012-13
2013-14
PRICE INDEXES: CPI based - INDIA
0.4

0.3

0.2

0.1

0.0

-0.1

AL IW UNME
-0.2
65 70 75 80 85 90 95 00
 PRICE INDEXES: CPI based - INDIA
40

30

20

10

-10
CPI_IW CPI_AL
IW - Food
-20
 Overview
1. How the Consumer Price Index (CPI) is
constructed.
2. Calculating Consumer Price Index and the
Inflation Rate.
3. Problems in measuring the cost of living.
4. Correcting economic variables for the
effects of inflation.
 Problems in Measuring The Cost of
Living
1. The CPI is an accurate measure of the
selected goods that make up the typical
bundle, but it is not a perfect measure of
the cost of living.
2. Three reasons/problems:
a) Substitution Bias
b) Introduction of new goods
c) Unmeasured quality change
Problems of CPI: Substitution Bias
a. The bundle does not change in the short run
to reflect consumer reaction to changing
relative prices.
Consumers substitute toward goods that have
become relatively less expensive.
CPI is computed assuming a fixed basket of goods.
The index overstates the increase in cost of living
by not considering the substitution by the
consumer.
Problems of CPI: New Goods
b. The bundle does not reflect the effects of new
products that typically go down in price after
introduction.
y New products result in greater variety, which in
turn makes each rupee more valuable. Consumers
need fewer rupees to maintain any given standard
of living.
y The CPI is based on a fixed basket of goods and
does not reflect the change in the purchasing
power of the rupee.
Problems of CPI: Quality Changes
c. Higher market prices usually include quality
changes that do not necess-arily represent a
higher cost of living.
If the quality of a good decreases from one year
to the next, the value of a rupee falls, even if the
price of the good stays the same.
The true cost of living may be less even though
some goods cost less/same.
Problems of CPI
1. The substitution bias, introduction of new
goods, and unmeasured quality change
tends to lead the CPI to overstate the
increase in the cost of living by about half a
percent (0.5 to 1%), indicted by some
research studies
2. This measurement error tends to overstate
the true cost of living.
The Consumer Price Index Vs the GDP
Deflator
1. The CPI:
includes only consumption goods
includes the cost of imports
is a fixed bundle of goods (old)
2. The GDP Price Deflator:
includes all final goods and services
excludes imports
Uses more recent bundle of goods
(new)

Y=C+I+G+X-M
 Overview
1. How the Consumer Price Index (CPI) is
constructed.
2. Calculating Consumer Price Index and the
Inflation Rate.
3. Problems in measuring the cost of living.
4. Correcting economic variables for the
effects of inflation.
Correcting Economic Variables for the Effects
of Inflation
1. Price indexes are used to correct for the
effects of inflation when comparing rupee
figures from different times.
2. When some rupee amount is
automatically corrected for inflation by
law or contract the amount is said to be
indexed for inflation.
e.g., Central Govt. Wage Contracts, Wages &
salaries of organized industry/service
employees, Railways, NREGS wages etc.
Correcting Economic Variables for the Effects
of Inflation

To convert (inflate) past wages

and prices into current terms:
Current Year Rupees =
Past Year Nominal Value X [(Price index in
current year) (Price index in past
year)] = [ (Wt-1) X (Pt) (Pt-1)
Correcting Economic Variables for the Effects
of Inflation

To convert (deflate) current wages and

prices into past year terms:

Value in Past Year Rupees =

Current Year Value X [(Price index in past
year) (Price index in current year)] = [Wt
X Pt-1 Pt]
Real and Nominal Interest Rates
Interest represents a payment in the future for a
transfer of money in the past.
1) Nominal interest rate:
y The rate that the bank pays in current value.
2) Real interest rate:
The interest rate corrected for inflation

Real interest rate = Nominal - Inflation

Real & Nominal Interest Rates
z Example - Assume:
1. You borrow Rs1,000 for one year.
2. Nominal Interest rate was 15%.
3. During the year inflation was 10%.

z The real interest rate is:

15% - 10% = 5%
Inflation and Interest Rates
Inflation creates a difference between
real and nominal interest rates
The nominal rate of interest is expressed in current rupees
as a %age of the amount loaned, common
The real interest rate is expressed in Rupees of constant
purchasing power as a %age of the amount loaded

Inflation risk makes some lenders offer

adjustable-rate loans
(e.g. Housing n Car Loans etc.)
 Conclusion
1. When comparing rupee values from
different times, it is necessary to keep in
mind that a rupee today is not the same
as a rupee in the past.
2. The CPI illustrates one way that prices
are measured and how to make
adjustments for these price changes.