Price Indices: Measures of Inflation

Inflation is defined as the a general and sustained rise in prices. Having covered its causes here: http://vskills.in/certification/blog/causes-of-inflation-part-1-demand-pull-inflation/ and here: http://vskills.in/certification/blog/causes-of-inflation-part-ii-cost-push-inflation/ , I will proceed to elaborate on the devices used to measure inflation.Inflation is measured by constructing inflation indices. Inflation indices indicate how much prices have changed over a period of time.

Why is it important to measure inflation?

First and foremost: Prices change. Inflation indices help map this change into the inflation rate. It is based on this information that everybody takes their economic decisions. Producers decide what, how and how much to produce, consumers decide what and how much and when to buy, governments (fiscal policy) and central banks (monetary policy) base their policy decisions on the inflation rate. The inflation rate is a crucial economic indicator, i.e. it shows the state of the economy and how a country treats its poor, the section of the society that is hit hardest by inflation. The inflation rate also helps us to distinguish the growth in nominal GDP output from real GDP and output. That is, it indicates how much an economy has really grown physically in terms of the goods and services it produces rather than how much it has grown only because of these goods and services getting expensive in monetary terms. Apart from this, we can also compare incomes in different countries because a price index gives us an accurate picture of how much value a currency has in its country and hence adjust incomes accordingly to arrive at the correct comparison.

What is an Inflation Index?

Inflation indices include price indices and the GDP deflator, i.e. they help in measuring inflation. A price index is the ratio of weighted average of prices in two time periods, which gives the general level of prices with respect to a year called the base year. Not all prices are included in the index, only a specified basket of good and services. The next article by me will cover how these indices are computed.

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