Inflation put simply is the rate at which the general level of prices for goods and services is rising, and subsequently how purchasing power is falling.
Conversely, deflation is the term for when these price levels decline.
The measurement of inflation may seem straightforward.
It's the percentage change in a price index over a specific time period.
Yet constructing these indices is a complex process.
Let's delve into how this is done.
Firstly, we select a representative basket of goods and services.
This basket is reflective of what a typical consumer or business would purchase laying the foundation for our consumer price indices, CPI and producer price indices, PPI, respectively.
The selection is informed by detailed surveys on spending behavior.
PPIs gauge the average change in the sales prices domestic producers receive for their goods and services over time.
It's a broad measure encompassing not just final goods, but also those used in production processes and capital goods.
PPIs are often viewed as precursors to CPI inflation, since any changes in the prices at the producer level tend to eventually percolate through to consumer prices.
CPIs, on the other hand, track the average price change over time for a basket consumed by households.
This basket spans a wide array of categories from food and clothing to significant expenditures like housing, transportation, and healthcare.
The CPI captures the end stage of the production process, the retail point of sale, thus including retail markups and sales taxes, which reflect the inflation rate experienced directly by consumers.
Next, we assign weights to each item within our basket corresponding to its significance in the average spending.
Housing costs, for example, are typically weighted more heavily in the CPI due to their substantial share of household expenses.
The third step is the rigorous collection of current prices for all items in our basket.
This task requires consistent surveys of retailers, service providers, and manufacturers to monitor the prevailing prices.
Finally, we calculate the index.
This involves comparing the current prices with those from a designated base period.
The prevalent method is the Laspeyres formula, which involves weighting the price of each item, summing these products for the current and Base periods, and then calculating the index levels.
The resulting figure is then converted into a percentage to reflect the rate of inflation.
To put this into context, if today's CPI reads 306.746 compared to 296.797 a year ago, we are looking at an annual inflation rate of 3.4%.
