Now as we have seen how inflation is calcualated with WPI , its now time to analyze

wthether WPI is a good measure of inflation or not.

Most of the major economies like US, UK, Japan, France, Singapore and even our arch
rival China have selected CPI as its official barometer to weigh its inflation. But our
country, India, is amongst few countries of the world, which selected WPI as its official
scale to measure the inflation in the economy.

The main difference between WPI and CPI is that wholesale price index measures
inflation at each stage of production while consumer price index measures inflation only
at final stage of production.

In last post we discussed about WPI, now let’s have a better understanding of CPI and
how it’s better from WPI:

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.

In use of WPI there are certain problems which have been encountered.
· Economists say that main problem with WPI is that more than 100 out of 435
commodities included in the index have abstained to be important from 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.
· WPI measures general level of price changes either at level of wholesaler or at the
producer and does not take into account the retail margins. Therefore we see here that
WPI does give the true picture of inflation.
· In present day service sector plays a key role in indian economy. Consumers are
spending loads of money on services like education and health. And these services are
not incorpated in calculation of WPI.
· Moreover the inflation figures that we get on Friday hardly makes a differnce to
consumers, as the commodites on which inflation is calculated are not part individual
consumers budget. Therefore in order to know what exact number of inflation is
affecting your budget , it is advisible you should do your own calculation. You can
compare your expenditure for previous years and with present scenario required to
maitain your lifestyle and you ill come to know that increase in expenditure would be a
few times higher than the official inflation figure.

But it is not easy for country like india to adopt to CPI , as 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.
Apart from this official staements say that there is too much of lag in reporting of CPI
numbers, which makes it difficult for india to calcualte inflation based on CPI figures.
India calcualtes inflation on weekly basis , whereas CPI figures are available on monthly
basis. So all this give little ground for indian government to adopt CPI in calculating
inflation.
The graph of inflation and that of the blood pressure of the United Progressive Alliance ministers have
become highly positively correlated, what with national election not very far away.

The issue

The graph of inflation and that of the blood pressure of the United Progressive Alliance ministers have
become highly positively correlated, what with national election not very far away.

Not surprisingly, we are witness to a flurry of frantic actions and threat of even more frantic fanatic actions
to show to the whole world (electorates) that the fight against inflation is very much on.

And, whenever that fails, one can always fall back on the tried and tested formula of blaming the global
phenomenon having engendered the local problem.

Not that this attribution is baseless. There is indeed no gainsaying the fact that inflation has indeed taken a
global hue with food and oil prices running amok all over the world. And, the rise in food and oil prices is
more a reflection of runaway commodity prices.

Inflation rate grew by a faster 7.60 per cent in May from 7.14 per cent in the previous month, on higher
prices of food items, including jaggery and fish.
The RBI Governor recently admitted that inflation in India's food prices is much higher than the country's
'tolerance limit' necessitating a comprehensive review of the situation." We anticipated some inflationary
pressures but it turned out to be more intense and we have to examine all aspects of the situation, both
global and domestic,

Rising prices have forced India's United Progressive Alliance government to take urgent measures -- like
banning export of non-basmati rice, pulses, edible oil and cement -- to rein in runaway inflation. High
inflation rate has taken a political colour in the country with the opposition Bharatiya Janata Party and Left
allies accusing the government of its failure to address the aam aadmi's woes.

According to India Inc, however, the highest point in inflation is yet to hit India. A new survey says that
nearly two-thirds of the executives in India expect prices to flare up in the next six months. The report --
Economic and Hiring Outlook, First Quarter 2008: A McKinsey Global Survey -- states that as many as 64
per cent of Indian executives expect the rate of inflation to rise in the next six month, while only 20 per cent
expect a decline in the rate of price rise.

Among the products primarily responsible for the current inflation are food products of different kinds,
including cereals, intermediates like metals and the universal intermediate, oil.

Some of the reasons for the spurt in prices of various commodities:

Impact of high oil prices: High crude oil prices affect agricultural costs directly because of the significance of
energy as an input in the cultivation process as well as in the transportation of food.

Increase use of bio-fuels: Many Western countries have promoted bio-fuels as an alternative to petroleum.
This has led to significant shifts in acreage as well as use of certain food grains. For example, Brazil uses
sugarcane to make bio-fuel and the European Union uses imported vegetable oils to make bio-fuel. This has
reduced the available land for producing food the world over. As global food and commodity prices rise, the
impact is felt by India too.

Neglect of agriculture: The prolonged agrarian crisis in many parts of the developing world; excessive use of
groundwater and inadequate attention to preserving or regenerating land and soil quality; lack of attention
to relevant agricultural research and extension; overuse of chemical inputs that have long-run implications
for both safety and productivity have cumulatively led to inflation.

Reversing these processes will take time and substantial public investment. Until then, global supply
conditions will remain problematic.

A change in market structure: This allows for greater international speculation in commodities. It is often
assumed that rising food prices automatically benefit farmers, but this is far from the case, especially as the
global food trade has become more concentrated and vertically integrated.

Individual households claim to have opted for major cuts in their daily budget. "If the government doesn't
do anything to address your woes, we are left with no option but to choose a lower standard of living," they
say in unison.

Some of the largest increases in food prices have been in Mumbai. Here food is brought over long distances
by truckers who are now paying much more for fuel as the government has passed part of the increase in
world oil prices on to the consumers.

Wholesale price index has accelerated to 6 per cent from 4 per cent in January. Consumer price indexes
have risen nearly 7 per cent in urban areas over the past year and almost 9 per cent in rural areas, where
more than two-thirds of the population lives and where higher food prices are having the worst effect.

According to small and medium level traders, they have been doubly hit. Rising prices are eating into the
volume of import of products; an increase in sales price tags is barring the entry of more consumers. "As a
result, they can import less and can sell even lesser amount of products," With prices of essentials going
through the roof, it has been extremely difficult for them to accumulate capital. As a result, they can
procure fewer amounts of goods and can sell even fewer products. Inflation is directly gnawing at their very
existence."

What is alarming is that small and medium businessmen are not backed by enough capital on which they
can fall back in a crisis and if this situation does not improve in a month or two, some like them will be
forced to wind up their business.

Life for the aam aadmi is becoming increasingly difficult because of all-round price rise across the country,
biting into the real incomes of the people.

Essential commodities are getting out of the reach of the poor and the middle class. The rate of inflation
reached beyond 7% per cent (week ended March), the highest in the last 13 months.

The situation has worsened by rounds of price hikes of petroleum products, which has had a cascading
impact on the prices of several commodities.

While economists think slow growth in farm output and rising demand are fuelling the prices, food
consumption by fast-growing China and bio-fuel demand are also pushing up prices, says the Reserve Bank
of India.

While the central government says it has taken various measures to try to boost food supply in the longer
term, there seems to be no short-term fix to bring prices down.

Data from the Price Monitoring Cell of the Department of Consumer Affairs of the Union government, which
collects data on 15 essential commodities from 18 centers across the country, show that prices of most of
the essential commodities monitored by the cell have experienced 20 to 40 per cent rise over the last few
years.
The fast growing developing economies, especially China and India, have been industrializing rapidly on the
back of still energy intensive technologies while growing incomes of a greater part of the population is
stimulating food demand. However, it does seem that price increases are not merely because of demand
supply mismatch.

The fact that commodity prices are still rising despite perceived threat of global growth slowdown including
that of Indian and China makes one believe that speculative activity is at play, especially in a commodity
like oil which has seen substantial built-up in speculative demand.

This is not surprising. With a slowdown in equity markets, there seems to have been a shift in asset class in
favour of commodities, leading to some speculative influence.

Question, however, is should global phenomenon be treated as a villain in the piece especially given the fact
that galloping food prices is a nightmare for any government facing inflation?

The Theory

An issue which has been causing grave concern to monetary authorities both in developed and in developing
economies in recent years has been the phenomenon of inflation. Inflation can be described as a situation
marked by a continuous increase in price level. The situation begins to cause worry when this increase in
price level exceeds a tolerable limit. When prices increase they do not affect all sections of the society
uniformly. When prices rise, some sections of society gain while other sections lose. The persistence of
inflation also causes permanent damage to society. It diverts investment into channels like acquisition of
land and other assets, which yield quick capital gains. When inflation continues over a period of time it also
erodes the motivation for saving. However. In controlling inflation the authorities must not only identify the
causes but also must evaluate other side effects that may arise as a result of the pursuit of anti- inflationary
policies.

Base on the source of inflationary pressures, it has been customary to distinguish three types of inflation,
demand pull, cost push and structural.

Demand Pull Inflation

Inflation, which is caused by excess demand, is described as demand-pull. When an attempt is made to
raise the level of aggregate demand from an existing level, it caused the price level to rise.

A shift in the aggregate demand curve can arise as a result of an increase in private as well as government
expenditures. Very often it is caused by an increase in government expenditure, which is facilitated, by an
increase in money supply.

Cost Push Inflation:

The main cause of inflation is traced to the shift in the aggregate supply curve. The shift in the aggregate
supply curve can occur as a result of the result of the rise in the wage rate. The cost-push inflation is very
often a case of wage push inflation.

Structural Inflation

The structural inflation thesis emphasis the possibility that even when there is no excess aggregate demand,
price level rises may rise because of excess demand situations in specific sectors.

Indicators and Measurement

Price Indices

Movements in prices have two aspects. One is the change in relative prices, which affect microeconomic
resource allocation and the other in the overall price level, which affect the purchasing power of money over
goods and services in general.

A variety of price indices are devised to capture this second aspect. IT is easy to measure changes in the
prices of individual commodities, but how does one work out the overall price increase in a whole basket of
commodities? This is what a price index does. There are three types of price indices viz., the Wholesale Price
Index ( WPI), the Consumer Price Index (CPI), and the GDP deflator.

The Wholesale Price Index ( WPI)

Measures changes in wholesale prices, it reflects producer inflation - the inflation facing producers in terms
of inputs

And

Consumer Price Index (CPI)

Measures changes in retail prices and hence inflation as it affects the consumer.

GDP deflator
It is defined as the ratio of current price GDP to constant price GDP.

To construct the index for a given year, with reference to a base year we need

Consumption basket in the base year

Prices of the items in the basket in the base year and
Price relatives for each item in the given year.
From (i) and (ii) we can get the weights w1…wn.

The Wholesale Price Index ( WPI)

In India the inflation rate, that is the rate at which the price level is increasing, is commonly measured by
the movements in the wholesale price index ( WPI). The index is a basket of 447 commodities and the base
year taken for giving weights to individual commodities is 1993- 94.

There are two WPIs. The first is called a point-to-point annual rate, which tells us what the rate of change in
wholesale prices is in a particular week of day in one year as compared to its level in the same week or day
the previous year. The other is what is called the annual average WPI rate, which is a 52 week average.

The items included in WPI are quite different. They include items like fertilizers, minerals, industrial raw
materials and semi- finished goods, machinery and equipments etc., apart from items in the food group and
in the fuel, light and power group. The WPI can be interpreted as an index of prices paid by producers for
their inputs.

Wholesale prices rather than retail prices are used. Thus for minerals ex-mine prices, for manufactured
products ex-factory prices, for agricultural commodities the first wholesaler’s prices etc., are used.

Weights are based on value of transaction in the various items in the base year. For manufactured products
it is the value of production, for agricultural products the value of marketable surplus etc.

The main groups of items are:

Primary Articles: food (Rice, wheat etc.), Non- food (raw cotton, jute etc.), Minerals (iron ore, manganese
ore etc.) In all 80 primary articles are covered.

Manufactured Articles: 270 items.

Fuel, Power, Light and Lubricants: 10 items

Wholesale price indices for individual commodities, commodity groups and the overall WPI are published
monthly by the Office of the Economic Advisor to the Government of India. They are reported in number of
other publications.

Consumer Price Index (CPI)

Before dealing with the CPI let us understand another commonly used term viz., the Cost of Living Index
( CLI). Changes in a true CLI would reflect changes in the money outlay required to maintain a given
standard of living for a representative family from a specified group such as ‘ urban wage earners’. Now
standard of living is a rather vague term.

In the microeconomic theory of consumer behaviour it is taken to mean a given level of ‘utility’ or
‘satisfaction’. A consumer can attain a given level of utility with a variety of combination of goods and
services. Which combination will actually be purchased depends upon the tastes of the consumer and the
relative prices of goods. We can only observe the actual purchases and not the level of satisfaction attained
by the consumer. Hence it is very difficult if not impossible to operationalise the concept of true CLI.

CPI is a compromise. Instead of a given standard of living, we compare, over time, the money outlays
required to purchase a given basket of consumption goods and services. The basket represents the actual
consumption pattern of a typical family from a specific group for which the CPI is being constructed. Since
tastes vary across families and relative prices can also vary geographically, a separate CPI is constructed for
each of a few well-defined population groups. Typical groupings are ‘ urban industrial workers’, agricultural
labourers’, ‘urban non-manual employees’ etc.

The rationale for differentiating between these three groups is that the basket of goods consumed by each
group will differ significantly from that consumed by the others. For example, the CPI for AL will typically
attach a higher weight to food groups, especially cereals, as it is assumed that agricultural labourers will
spend a higher proportion of their wages on food than on, say, commuting. Conversely, the weight attached
to transport costs would typically be higher in CPI-UNME than it would be in CPI-AL. Also, certain
commodities consumed by one class may simply not be available, wholly or partly, to the consumption
basket of another class of consumers.

The preliminary to constructing a CPI for any class of consumers would be to identify the items, which form
a major part of the consumption basket of the class as a whole. This can only be achieved by means of a
household survey. Next, each item would be assigned a weight in the overall index in proportion to its share
in total expenditure. The index reflects nothing but the weighted average of each commodity's price. An
appropriate base year is selected, in which the price of each commodity, and hence the overall index, is
equated to 100. This base is then used as a benchmark for future prices.

Thus, if potatoes cost, say, Rs 10 per kg in the base year and Rs 20 in a subsequent year, the potato index
for the later year would be 200. What the weights do is to assign degrees of importance to different
commodities. Thus, if house rent has a 25% weight in the CPI-UNME, and rents increase by 20%, this will
lead to a 5% increase in the overall CPI-UNME, other things remaining the same. On the other hand, if
watches have a weight of only 1%, even if their prices were to double, this would affect the overall index by
only 1%.
It is indeed true that consumption patterns change over time. If the CPI for a particular class is to remain
relevant, it must be constantly updated. This means a fresh survey leading to a new set of commodities and
weights, and hence an all-new base. This apart, you could have situations where the commodity used in the
basket has been replaced by a somewhat superior version, the original one no longer being available. For
instance, mechanical watches may disappear altogether, to be replaced by quartz watches. It would clearly
be misleading to disregard this change. This is taken into account by what is called 'splicing'. The new prices
are adjusted for the fact that the item in question is superior to the original one.

The CSO (Central Statistical Organization) is now considering constructing a general CPI, not taking into
account different consumer groups. So far, macro-economic analysis typically uses the WPI, which may not
be an accurate indicator of inflation faced by end-consumers, as wholesale and retail prices can be
substantially different. A general CPI would be more relevant in this regard.

In practice it is not feasible to include each and every consumption item individually. Items are grouped
together into a small number of groups e.g. ‘food’,’pan, supari, tobacco and intoxicants’,’fuel and
light’,’housing’,’vegetables and fruits’ etc. with further sub grouping e.g. within food we can have ‘cereals’,
‘pulses and products’, ‘oils and fats’ etc.

The consumer price index ( CPI) put out monthly by the Ministry of Labour. Three CPIs are published - for
individual workers (CPI-IW) for urban non-manual employees (CPI- UNME) and for agricultural labour ( CPI-
AL). The CPI that is watched with greatest interest is the CPI -IW, since it is used to calculate the dearness
allowance (DA) to be paid to the employees in the organized sector. Its base is 1982 and it covers 260
commodities. Data is collected form 70 centers around the country.

However, to sustain low inflation, the syndrome of what economists call "high long- term inflationary
expectations" has to be addressed.

The WPI which uses 1993-94 as the base year and covers 435 items is called the "headline" rate of inflation
since it is the rate that captures news every Monday.

A current inflation rate has both a permanent and transient segment. Transient components arise from
sudden shocks - like when the prices of onions or crude oil shoot up or when the prices of edible oils come
crashing down. According to economists the permanent component is known as the " Core Inflation". It is
the future underlying rate of inflation anticipated by economic agents that does not change with changes in
output - either up or down.

Both inflationary expectation and inflationary experience need to be tackled.

Core inflation refers to the systemic inflation in the economy. It is a measure of inflation that adjusts for the
impact of supply shocks or any other specific factors related to inflation in particular items. It is a refined
measure of inflation looked at by the central bankers, since it bears a greater correlation with the money
supply and liquidity than the usual measures of inflation.

There are mainly two methods of computing core inflation. In the trimmed average method, the items that
have the maximum variation in prices on both sides (increase as well as decline) are ignored and the
inflation rate for the remaining basket of items is computed. Thus, this method ignores the impact of items,
whose prices are reflecting the item-specific movements.

In the second method, those groups / items are excluded (on a-priori basis) whose prices are believed to be
usually responding to the supply-side factors. The fuels group and perishable agricultural commodities are
typically excluded in such a measure. In India, the inflation rate for the manufactured products' group is
largely considered to be the core inflation prevailing in the economy. More refined estimates of core inflation
- based on the trimmed average method - are occasionally declared by the Reserve Bank.
Prof. M. Guruprasad
Aicar Business School