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Inflation Part 2

Inflation aims to measure the overall impact of price changes for a diversified set of goods and services in an economy over time. The three main causes of inflation are demand-pull inflation, which occurs when increased money supply stimulates demand faster than production can increase; cost-push inflation, which occurs when costs of production increase; and built-in inflation, which occurs when people come to expect ongoing inflation and demand higher wages to maintain purchasing power. Inflation is commonly measured using price indexes like the Consumer Price Index (CPI) and Wholesale Price Index (WPI)/Producer Price Index (PPI), which track changes in consumer and producer prices respectively.

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62 views4 pages

Inflation Part 2

Inflation aims to measure the overall impact of price changes for a diversified set of goods and services in an economy over time. The three main causes of inflation are demand-pull inflation, which occurs when increased money supply stimulates demand faster than production can increase; cost-push inflation, which occurs when costs of production increase; and built-in inflation, which occurs when people come to expect ongoing inflation and demand higher wages to maintain purchasing power. Inflation is commonly measured using price indexes like the Consumer Price Index (CPI) and Wholesale Price Index (WPI)/Producer Price Index (PPI), which track changes in consumer and producer prices respectively.

Uploaded by

May Wenhetten
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Understanding Inflation

While it is easy to measure the price changes of individual products over


time, human needs extend beyond just one or two products. Individuals
need a big and diversified set of products as well as a host of services for
living a comfortable life. They include commodities like food grains, metal,
fuel, utilities like electricity and transportation, and services like healthcare,
entertainment, and labor.

Inflation aims to measure the overall impact of price changes for a


diversified set of products and services. It allows for a single value
representation of the increase in the price level of goods and services in
an economy over a period of time.

To combat this, the monetary authority (in most cases, the central bank)
takes the necessary steps to manage the money supply and credit to keep
inflation within permissible limits and keep the economy running smoothly.

Theoretically, monetarism is a popular theory that explains the relationship


between inflation and the money supply of an economy. For example,
following the Spanish conquest of the Aztec and Inca empires, massive
amounts of gold and especially silver flowed into the Spanish and other
European economies. Since the money supply rapidly increased, the value
of money fell, contributing to rapidly rising prices.2

Inflation is measured in a variety of ways depending on the types of goods


and services. It is the opposite of deflation, which indicates a general
decline in prices when the inflation rate falls below 0%. Keep in mind that
deflation shouldn't be confused with disinflation, which is a related term
referring to a slowing down in the (positive) rate of inflation.

Causes of Inflation
An increase in the supply of money is the root of inflation, though this can
play out through different mechanisms in the economy. A country's money
supply can be increased by the monetary authorities by:

 Printing and giving away more money to citizens


 Legally devaluing (reducing the value of) the legal tender currency
 Loaning new money into existence as reserve account credits
through the banking system by purchasing government bonds from
banks on the secondary market (the most common method)
In all of these cases, the money ends up losing its purchasing power. The
mechanisms of how this drives inflation can be classified into three
types: demand-pull inflation, cost-push inflation, and built-in inflation.

Demand-Pull Effect
Demand-pull inflation occurs when an increase in the supply of money and
credit stimulates the overall demand for goods and services to increase
more rapidly than the economy's production capacity. This increases
demand and leads to price rises.

When people have more money, it leads to positive consumer sentiment.


This, in turn, leads to higher spending, which pulls prices higher. It creates
a demand-supply gap with higher demand and less flexible supply, which
results in higher prices.

Built-in Inflation
Built-in inflation is related to adaptive expectations or the idea that people
expect current inflation rates to continue in the future. As the price of
goods and services rises, people may expect a continuous rise in the
future at a similar rate. As such, workers may demand more costs or
wages to maintain their standard of living. Their increased wages result in
a higher cost of goods and services, and this wage-price spiral continues
as one factor induces the other and vice-versa.

Types of Price Indexes


Depending upon the selected set of goods and services used, multiple
types of baskets of goods are calculated and tracked as price indexes. The
most commonly used price indexes are the Consumer Price Index
(CPI) and the Wholesale Price Index (WPI).

The Consumer Price Index (CPI)


The CPI is a measure that examines the weighted average of prices of a
basket of goods and services that are of primary consumer needs. They
include transportation, food, and medical care.

CPI is calculated by taking price changes for each item in the


predetermined basket of goods and averaging them based on their relative
weight in the whole basket. The prices in consideration are the retail prices
of each item, as available for purchase by the individual citizens.

Changes in the CPI are used to assess price changes associated with
the cost of living, making it one of the most frequently used statistics for
identifying periods of inflation or deflation. In the U.S., the Bureau of Labor
Statistics (BLS) reports the CPI on a monthly basis and has calculated it
as far back as 1913.3

The Wholesale Price Index (WPI)


The WPI is another popular measure of inflation. It measures and tracks
the changes in the price of goods in the stages before the retail level.

While WPI items vary from one country to another, they mostly include
items at the producer or wholesale level. For example, it includes cotton
prices for raw cotton, cotton yarn, cotton gray goods, and cotton clothing.

Although many countries and organizations use WPI, many other


countries, including the U.S., use a similar variant called the producer price
index (PPI).6

The Producer Price Index (PPI)


The PPI is a family of indexes that measures the average change in selling
prices received by domestic producers of intermediate goods and services
over time. The PPI measures price changes from the perspective of the
seller and differs from the CPI which measures price changes from the
perspective of the buyer.7

In all variants, it is possible that the rise in the price of one component (say
oil) cancels out the price decline in another (say wheat) to a certain extent.
Overall, each index represents the average weighted price change for the
given constituents which may apply at the overall economy, sector, or
commodity level.

The Formula for Measuring Inflation


The above-mentioned variants of price indexes can be used to calculate
the value of inflation between two particular months (or years). While a lot
of ready-made inflation calculators are already available on various
financial portals and websites, it is always better to be aware of the
underlying methodology to ensure accuracy with a clear understanding of
the calculations. Mathematically,

Percent Inflation Rate = (Final CPI Index Value/Initial CPI Value) x 100
Say you wish to know how the purchasing power of $10,000 changed
between September 1975 and September 2018. One can find price index
data on various portals in a tabular form. From that table, pick up the
corresponding CPI figures for the given two months. For September 1975,
it was 54.6 (initial CPI value) and for September 2018, it was 252.439 (final
CPI value).89
Plugging in the formula yields:

Percent Inflation Rate = (252.439/54.6) x 100 = (4.6234) x 100 = 462.34%


Since you wish to know how much $10,000 from September 1975 would
worth be in September 2018, multiply the inflation rate by the amount to
get the changed dollar value:

Change in Dollar Value = 4.6234 x $10,000 = $46,234.25


This means that $10,000 in September 1975 will be worth $46,234.25.
Essentially, if you purchased a basket of goods and services (as included
in the CPI definition) worth $10,000 in 1975, the same basket would cost
you $46,234.25 in September 2018.

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