Measuring Inflation

Inflation, which refers to a general rise in the average level of prices, can be measured in a variety of ways. Strictly speaking, there is no single 'measure' of inflation - only indicators of inflation.

By this we mean that the subjective experience of inflation will vary considerably between people and households. This is because no two individuals or families will consume exactly the same combination of goods and services. Hence, it is unlikely that a rise in the 'average' level of prices will be experienced in the same way. 'My' inflation rate is different from 'your' inflation rate.

So, is there any point to measuring inflation?

The most important reason to establish an accepted measure of inflation is that changes in the price level have fundamental and wide-ranging effects on all aspects of an economy, including living standards, growth, jobs and the balance of payments. While not perfect, it is essential that average prices can be tracked over time.

Levels and rates

Firstly, we need to distinguish between measuring the price level, and measuring the rate of inflation.

The price level

The price level is simply the average prices of all goods (or those measured) at a point in time. For example, if a family in Spain purchases 7 goods on a particular Saturday - a loaf of bread at €3, a bunch of bananas at €2, a kilo of rice, at €6, a newspaper at €3, some asparagus at €4, a bottle of water at €2, and an ice cream at €1, the price level they face is the average of all prices, which is €3 [total prices of €21 divided by 7 goods].

Inflation basket for a famility.

The inflation rate

The rate of inflation is the increase in the price level expressed as a percentage. The distinction between the rate and the level is important. Referring to changes in the price level is not the same as referring to changes in the inflation rate. While the rate of inflation could be falling, the price level is still rising, but at a slower rate. A falling inflation rate is still a rise in average prices - this is one of the commonest misconceptions regarding the measurement of inflation.

Using an index

Inflation can only sensibly measured by using an 'index'. This is because there is no single number which represents all of the goods and services that exist, and are subject to prices changes.

An index is a mathematical device which tracks changes in a number from a starting point - commonly a base year - and is expressed in terms of the number 100.

Index numbers

The price level is likely to change over time, and it is far more convenient to track the changing number using an index, where the result can be compared with a starting number of 100.

Index formula

Inflation basket for a family.

For example, if we apply the information we have on the Spanish family, the starting value is €3, and if there is no change in price, the index value would be:

Inflation basket for a family - example.

Let's say that in the second week (week 2) the price of newspapers increase from €3 to €4, and the price of asparagus increases from €4 to €5, but bottled water is cheaper, falling from €2 to €1.

In this case the price level faced by the family has risen to 22/7, which is €3.14.

Inflation basket for a family- example two.

The new index number for the price change is 104.67. Hence, the index value is a convenient way of showing the percentage change in the price level - in this case, inflation is 4.67%. It is worth noting that, unless the Spanish family increases their income over the period, the increase in the price level will make them worse off in 'real' terms.

Conversely, if the price level falls (in week 3), the index will drop below 100. For example, if the basket of 7 goods drops to €2.90, the new index (compared with the base figure), is:

Inflation basket for a family - example three.

Making the index representative

However, there is an important issue to consider - if we simply add up the prices changes for a basket, and then create an 'average' this will not provide us with the real picture.

This is because the measurement of inflation needs to have a subjective element in it to reflect the fact that households do not experience inflation in the same way. For our family, if bread and ice creams both increase in price by 10%, this does not mean that there is a 10% impact on their 'experience' of inflation?

Consider their basket of 7 goods, with the individual prices shown in percentage and index form. A simple average is shown below:

Item Price rises
Bread 10%  (index = 110)
Rice 8%  (index = 108)
Newspaper 4%  (index = 104)
Water 4%  (index = 104)
Bananas 0 - (index = 100)
Ice cream 0 - (index = 100)
Asparagus -5% (index = 95)
AVERAGE PRICE RISE = 721/7 = 103 (index value)

However, this does not mean that the family's experience of inflation is that prices have risen by 3%. The mean average is 3%, but what if the family buys a newspaper every day, and only buys asparagus and ice cream as luxuries and only occasionally. How do we solve this?

The subjective experience of inflation really depends (at least in large part) on the percentage of income spent over time, which depends on the price and the frequency of purchases. Look at the table:

Item Income spent %
Bread 30
Rice 25
Newspaper 15
Water 10
Bananas 8
Ice cream 7
Asparagus 5

So, any increases in the price of bread or rice (which account for 55% of spending) will have a greater impact than increases in the price of ice cream and asparagus (which account for just 12% of spending).

Weighting the index

The solution to the problem is to 'weight' the various items according to the income spent on them over a period of time.

The simplest way to add a weight is to multiply the individual inflation rate by the chosen index number (and then divide by the number of weights allocated, as shown in the table:)

Item Income spent % = weights Individual inflation (%) and index Weighted index
Bread 30 10%  (index = 110) 30 x 110 = 3300
Rice 25 8%  (index = 108) 25 x 108 = 2700
Newspaper 15 4%  (index = 104) 15 x 104 = 1560
Water 10 4%  (index = 104) 10 x 104 = 1040
Bananas 8 0 - (index = 100) 8 x 100 = 800
Ice cream 7 0 - (index = 100) 7 x 100 = 700
Asparagus 5 -5% (index = 95) 5 x 95 = 475
TOTALS 100 weights 10575
    Divide the weighted index [10575] by the weights [100] 105.75

When taking income into account, the index of inflation for the family is 105.75, which means that, as a percentage, inflation was 5.75% over the period (and not the mean average of 3%). Hence a weighted index provides a more 'representative' picture of inflation for this family.

Of course, the weights could be reduced 10 in total, or increased to 1000 - the key point is that whatever the total weights are, once they have been used to create the weighed index, the same number is used to create the final index figure.

Key features of a price index

Key features

  1. The use of samples - not all goods and services are included in the basket, only typical ones and not all outlets.

  2. Surveys are conducted to decide which goods and services are included.

  3. The basket can be updated to reflect changes in spending patterns.

  4. Goods are weighted according to the importance of the good or service in the typical family's spending.

  5. Tracking starts with a base year and uses 100 as a starting measure.

  6. However:

  7. The sample may not be fully representative.

  8. The basket could be slow to update.

  9. Sudden changes in price - such as through an oil price shock - may not be reflected in the index.

Cost-push inflation

What causes cost-push inflation?

Demand-pull inflation

What causes demand-pull inflation?

Demand pull

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