We already know from the previous article introducing inflation that the ideal rate of inflation in a country is to rise by 2% per annum. It is usually measured by The Consumer Price Index (CPI).
We will now consider briefly how inflation is measured by governments in modern economies. Inflation is typically measured using an inflation index, also known by another name as a price index.
How does an inflation index, or a price index, work?
An index number is used to record average prices of a large number of the goods and services sold in a country over a period of time.
Every month, the government records changes in the prices of items that are commonly featured in a typical household’s budget.
Then, the prices of items recorded this month are compared to those of the previous month, and the previous year as well. Additionally, the items are weighted to reflect the importance of each item in a household budget. It is because while people drink water and eat food every day, they go to the cinema maybe a few times a year only. So, food will have greater weighting than entertainment.
At the end, all weighted price changes are averaged and the index is given the final number for that particular month, e.g. 105. This index number is easy to compare with past periods.
Let’s see what that number means. In August 2021, The Consumer Price Index (CPI) stood at 105 comparing with the previous month, July 2021. It means that the weighted average of price inflation over this period was 5%. This means that inflation was 5% since last month. So, the money lost 5% of its value in just one month.
If the index value remains at 100, it means that the rate of inflation was 0% in the period measured.
Examples of an inflation index, or a price index
Typically, there are several indices are used by the government‘s statistics bureau to measure growth of prices in the economy. But, two of them are the most commonly used around the world:
1. A Consumer Price Index (CPI). Measures changes in the prices of goods and services bought by households. It usually includes housing costs such as food, clothes, utilities, healthcare, transportation, entertainment, etc.
Example 1: In August 2021, The Consumer Price Index (CPI) annual rate in the UK was 3.2% comparing with the same period last year, according to Office for National Statistics.
2. A Producer Price Index (PPI). Measures changes in the prices of goods bought and sold by manufacturers. It usually includes input prices (e.g. raw materials, packaging, fuel, etc.), and output prices (i.e. prices of finished products at the factory gate ready to be shipped to customers).
Example 2: In August 2021, the annual rate of input prices for The Producer Price Index (CPI) in the UK was 11% comparing with the same period last year. And, the annual rate of output prices for The Producer Price Index (CPI) in the UK was 5.9% comparing with the same period last year, according to Office for National Statistics.
