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Inflation

Introduction:
Inflation is a general rise in prices of goods and services. Inflation results in loss of value of money. If some commodity demands a price of 10 rupees 10 years ago, it now demands Rs. 50. This means there is loss in value of rupee by about five times w.r.t. to that commodity. So in general all commodities appreciate over time When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account within the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.

How is inflation measured?


Measuring inflation is a difficult problem for government statisticians. To do this, a number of goods that are representative of the economy are put together into what is referred to as a "market basket." The cost of this basket is then compared over time. This results in a price index, which is the cost of the market basket today as a percentage of the cost of that identical basket in the starting year.

A numerical example makes this procedure clear. Suppose a representative market basket of weekly expenditures of teenagers is three hamburgers, eight colas, and one gallon of gasoline. With the prices of year 1 shown in the table below, the cost of the market basket is $5.00. In year 2 two prices have risen and one has declined. Yet one can say that on the whole the price level has risen because the cost of the market basket has risen to $5.50. This is an increase of 10% (50/500 = 10%). From year 2 to year 3 prices change again, and the cost of the market basket goes up by another $.50. In year 3 the price level is 20% higher than it was in year 1 ([600 - 500]/500 = 20%), and 9.1% higher than in year 2 ([600 - 550]/550 = 9.1%).

COMPUTING A PRICE INDEX


. Hamburgers Colas Gasoline Cost of the Market Basket Price Index AMOUNT 3 8 cans 1 gallon PRICE YEAR PRICE YEAR PRICE YEAR 1 2 3 .75 .25 .75 5.00 100.00 .70 .30 1.00 5.50 110.00 .90 .30 .90 6.00 120.00

To compute the price index, the cost of the market basket in any period is divided by the cost of the market basket in the base period, and the result is multiplied by 100. In the table above, year 1 is the base year. The price index for year 3 is: Price Index = (P3/Pb) x 100 = (6.00/5.00) x100 = 120.00 The price index tries to give in one number a general picture of what is happening to a great many numbers. As the example shows, some prices may actually be declining while the price index is rising. These prices were not ignored by the price index; rather their contribution was less important to the overall result than the contribution of items whose prices rose.

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