Measuring Inflation and Deflation
Inflation or Deflation in an economy is measured by the help of Consumer Price Index (CPI).
It measures the changes in the price level, cost of living over a period of time. It is
constructed by considering a ‘basket’ containing various goods and services consumed by a
typical household in the course of a year. CPI is constructed to show how the value of the
basket changes from year to year by comparing its value from the year of comparison called
base year.
PROBLEMS WITH CPI/ LIMITATIONS
1. The rate of inflation calculated by CPI reflects the change in average prices of goods
and services. However, different consumers may have different consumption patterns
depending on their level of income. The changes in consumption pattern over time is
not vividly reflected through CPI.
2. In many countries, consumers increasingly make use of discount stores and sales, thus
buying some goods and services at lower prices than those used in CPI calculations.
This provides misleading information.
3. There can be changes in consumption patterns due to introduction of new products in
the market. This also leads to misleading information.
4. There is also change in the quality of the product over time. However, this is not
reflected through CPI.
5. CPI data cannot be effectively used for international comparison. This happens as
different countries follow different methods of calculations and basket of
commodities also differ.
6. Comparability overtime also becomes a problem when different countries follow
different base years.
PRODUCER PRICE INDEX (PPI)
It measures price level changes from the point of view of producers rather than consumers.
Price level changes measured by PPI are considered to be predictors of changes in the
consumer price index and hence predictors of the rate of inflation, because they measure
price changes at an earlier stage in the production process. For example if prices of inputs or
intermediate prices are rising, it is likely that the prices of the final product paid by
consumers will also rise.
The core rate of Inflation
Certain goods such as food and energy products (oil) fluctuate widely over short periods of
time. When such goods are included in the CPI, they may give rise to misleading impressions
regarding the rate of inflation. To deal with this problem the economist measures a core rate
of inflation, which is usually done by constructing a CPI that does not include food and
energy products.
CONSEQUENCES OF INFLATION AND DEFLATION
INFLATION:-
1. Redistribution effects:- Inflation redistributes income away from certain groups in
the economy towards other groups.
Groups who lose from inflation:-
a. People who receive fixed incomes or wages
b. People who receive incomes or wages that increase less rapidly than the rate of
inflation.
c. Holders of cash
d. Savers
e. Lenders
Groups who benefits from inflation:-
a. Borrowers (debtors)
b. Payers of fixed income or wages
c. Payers of income or wages that increase less rapidly than the rate of inflation.
2. Uncertainty:- Inability to predict what inflation will be in the future means that
people cannot predict future changes in the purchasing power, this causes
uncertainty that leads them to make fewer investments, which in turn may lead to
lower economic growth.
3. Less savings:-In order to maintain the real value of savings, savers must receive a
rate of interest that is at least equal to the rate of inflation. If the rate of interest
received on the savings is lower than the inflation rate the saver will be in loss as
the real value of their savings (purchasing power) will fall. For example someone
deposits $1000 in the bank ,the interest he receives is 3% and the inflation rate is
5% .
4. International Competitiveness:- When the price level within a country increases
relative to the price level of other countries with which it trades, its exports
become more expensive and imports cheaper; reducing the level of
competitiveness for the country and even affects its BOP.
5. Other costs:- Money illusion, Menu costs, impact on growth and inefficient
resource allocation.
DEFLATION:-
1. Redistribution effects:- Deflation redistributes income away from certain groups in
the economy towards other groups.
Groups who benefits from deflation:-
a. People who receive fixed incomes or wages.
b. Holders of cash
c. Savers
d. Lenders
Groups who lose from deflation:-
a. Borrowers (debtors)
b. Payers of fixed income or wages
2. Uncertainity:- Firms are unable to forecast their costs and revenue due to declining
price levels.
3. Risk of bankruptcies and financial crises:- Recession,-less income- more debt leads
to bankruptcies of firms and consumers who are unable to pay back their debts.
4. Risk of Deflationary spiral with high and increasing cyclical unemployment:- A
deflationary spiral involves a process where deflation sets into motion a series of
events that worsens deflation.
Spending and borrowing falls- unemployment increases- Income falls - leads to
further fall in spending
Deflationary spiral
5. Other costs:- deferred consumption, increase in the real value of debt, inefficient
resource allocation and policy ineffectiveness.
