Calculating Price Indices

 Inflation is measured by constructing inflation indices. Inflation indices which help in calculating inflation rates indicate how much prices have changed over a period of time. The indices themselves are a representation of the level of prices at a particular time.

• Choosing a base year:

To measure the change in the general price level today, current prices have to be compared to some period before. This period is called the base year. The base year should be a year of normal and stable economic conditions and should not be too distant in the past. It is advisable to update the base year with the passage of time (many developed and emerging nations follow the norm of updating their base years every 5 years), so as to make the comparison of prices more effective and relevant.

• Selecting a suitable basket of items:

It is not possible to take into account all the items whose price changes are to be represented by the price index, thus only those items of common use which are representative of the tastes, necessities, etc of people to whom the index is related. The basket should also be updated frequently to factor in new items in the market and leave out the obsolete ones.

• Attaching weights to the items:

Every category of the items in the basket is attached some weight, to represent its importance relative to the other items, giving a truly general picture of the prices. For e.g. in the CPI, weight is attached to a particular item according to its share in the total consumption of households. In the WPI, weights are attached according to the share of the items in total production.

• Calculating the inflation rate from the index:

The index is scaled so that it is equal to 100 in the base year. The index of the current year is the ratio of the current year prices to the base year prices (both multiplied by the weights), which is then multiplied by 100 so that the value of this index and all further indices is a percentage relative to the index in the base year. The inflation rate is then calculated as follows:

For e.g. if the base year is 2000 then the index in this year is 100 and if the index in the year 2001 is 104 upon calculation, then the inflation rate becomes:

(104-100) ×100= 4%

100

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