Table of Contents

What is inflation?

Unless you have been living under a rock, you would have observed that prices of things rise every year.

Inflation is the rate of increase in prices as compared to the previous year.

Most governments calculate inflation every month.

How is inflation calculated?

Step 1 - Survey

Governments survey the population regarding their preferences and find how they spend their income

A basket of goods is formed of these items according to their weights.

Step 2 - Select a base year

Value of basket of goods is calculated for each year.

Government arbitrarily decide to consider one of the years as base year, whose value is taken as 100.

Corresponding value of other years is calculated.

These values are also called consumer price index(CPI).

Step 3 - Calculate inflation

Inflation is the rate of change in CPI. For example inflation in year 2013 will be:

This 5% inflation is also known as consumer price inflation because it is calculated based on basket of goods purchased by regular consumers.

Why do government manipulate inflation data?

  • Salaries of government employees, social security programs are adjusted every year depending on the inflation rate. Government can save a lot of money by not having to adjust the salaries by a large number.
  • Various economic health parameters like nominal GDP are adjusted based on inflation. Governments want to inflate these numbers to portray their good image.
  • Inflation makes life of the population much harder. Government admitting a high inflation number is admitting that they could not foresee and make policies to control inflation.

How is inflation data manipulated?

How the survey is conducted

Government carries out ground survey of population regarding their preference and market for the prices. No one can be sure that the data is not manipulated at the survey stage itself.

Housing component

House is a basic human necessity. Housing forms a major part of basket of goods for calculating inflation.

Earlier housing was calculated as a measure for buying and renting a house.

It was replaced by “rent equivatent model” in 1990s. It means that government calls up random people(Not homeowners, renters or people looking to buy new homes) and asks what they would pay if they rented the house to themselves.

A case of complicating simple calculations that could have been easily measured by visiting any real eatate marketplace website.

Substitution effect

Government changes the basket of goods depending on changes in people preferences.

Imagine you like to eat beef steak. However, due to inflation steak become so expensive that you now have to eat soy that you hate.

The government substitutes steak with soy in the basket of goods and shows no inflation. Not considering that you could not buy steak because of inflation in the first place.

Quality improvements

Entrepreneurs work hard to improve their products and make them cheaper every year. For example phones available in the market are vastly superior and cheaper than the phones that were available a few years back.

Governments adjust the inflation downwards citing that consumers are able to get higher quality for the same price hence the price has effectively fallen.

Quality changes

Not all inflation is increase in price, it could also be loss of quality.

Imagine a company selling milk does not increase its price but dilutes it with water because of inflation. The end result is the same –  the consumer gets less for his money.

However, this does not have any effect on inflation numbers being calculated by the government.

Base effect

Inflation is measured as rate of change and not an absolute number. Hence inflation numbers come down even if the prices of goods continue to remain high.