a.  Inflation is an increase in the level of prices in the economy. It is a sustained rise in the overall levels of prices.

     i.  It is pro-cyclical with a lag of a minimum of a year or more. That is, inflation might not be present today but the conditions do exist in the economy that may indicate its certainty in the future.

    ii.  The inflation rate is the percentage change in a price index. It is considered a lagging indicator.

   iii.  However, the expectation of inflation is considered a leading indicator.

   iv.  The purchasing power of money decreases.

    v.  The liability of the borrower decreases if the loan has fixed monetary terms.

b.  Some of the other terminologies that are inevitable while discussing inflation are:

     i.  Deflation is a sustained decrease in the aggregate price level (negative inflation rate). The purchasing power of money increases. The liability of the borrower increases if the loan has fixed monetary terms.

    ii.  Hyperinflation is an extremely fast increase in the aggregate price level. It generally occurs when government spending is not backed by tax revenues and the money supply is increased (or unlimited).

   iii.  Disinflation is a decline in the inflation rate.

Note: One should not get confused between the meaning of deflation and disinflation.

1.1.         Measuring Inflation

a.  Inflation can be measured using the price index. It reflects the weighted average price of the basket of goods and services with respect to the index of hundred at a specified base year. The price index in any given year, say year x, can be calculated as follows:

b.  There are different types of indices, such as the Laspeyres Index, Fisher’s Index, Paasche’s Index, etc.

c.  Laspeyres Index: It is a price index in which the basket of goods and services is held constant. That is, the composition of the representative basket is held constant as in the base year.

     i.  Thus, the value of the index is calculated as follows:

    ii.  There are certain biases associated with the use of the Laspeyres Index. They are:

             a) Substitution Bias: People may substitute goods and services they are consuming with a change in their prices.

             b) Quality Bias: The utility of the goods and services may improve over time, as a result of improvement in quality. However, this may be interpreted as a price increase only.

            c) New Product Bias: Some important new products may not be included in the fixed baskets of goods and services.

d.  Paasche’s Index: This index tries to mitigate the substitution and quality biases by weighting the current year’s quantity at the current year’s prices against the current year’s quantity weighted at the base year’s prices.
The Paasche’s Index can be calculated using the following formula:

e.  Fisher’s Index: This is a chained price index. It can be calculated by taking the geometric mean of the Laspeyres Index and the Paasche index. That is:

1.2.         Usage of different Indices

a.  We have discussed above, how different indices are calculated. These indices may differ from each other with respect to names, weights, and methodology used in their calculation:

     i.  The indices may be called with different names in different countries such as the Consumer Price Index (CPI) in the US, Harmonized Index of Consumer Prices (HICP) in Europe, the Personal Consumption Expenditure (PCE), etc.

    ii.  Different countries may use different weights for the goods and services forming the basket. These weights may reflect different domestic conditions in the respective countries, different preferences, and constraints, etc.

   iii.  There may be different methodologies used for the calculation of the index. For example:

             a) The consumer price index (CPI) is used to track inflation within a given economy. In the United States, the CPI covers only urban areas. It is used by US Treasury inflation-protected securities (TIPS) and other contracts.

            b)  The personal consumption expenditures (PCE) price index covers all consumption using surveys.

b.   The producer price index (PPI), also known as the wholesale price index (WPI), tracks inflation in prices of goods and services to domestic producers.
The changes in PPI may lead the changes in CPI.

c.  There are other uses of these indices as well:

     i.  The bonds, contracts, leases, pensions, labor contracts, etc. may be indexed to some of the major price indexes.

    ii.  Different central banks use different measures of inflation, such as ECB follows HICP, Reserve Bank of India follows Wholesale Price Index (WPI), etc.

   iii.  The nominal GDP is adjusted to real GDP by a price index, also called the GDP deflator.

d.  Finally, there may be the use of headline inflation versus core inflation.

     i.  The headline inflation is the normal inflation.

    ii.  The core inflation, on the other hand, is the headline inflation less the inflation on the prices of energy or food, as these are considered more volatile.

1.3.         Explaining Inflation

a.  Inflation may be of two types: the cost-push inflation and the demand-pull

b.  Cost-push: Rising costs to businesses result in increased prices to consumers.

     i.  The major factor that pushes the cost of production in most of the countries is the labor cost.

    ii.  If the unemployment in the country is above the natural rate, there is very little wage inflation pressure; but as the unemployment rate falls below that level there is a rising wage inflation pressure.

   iii.  Wages alone are not a good indicator of cost-push inflation; the indicator should reflect the overall productivity. Thus, a measure of the cost-push inflation could be:

Unit / Labor Cost = (Total Wages Per Hour) / (Output Per Hour)

c.  Demand-pull: Prices increase because of an increase in demand.

     i.  Money supply indicators and money supply growth compared with growth in the nominal GDP could be a good measure of the demand-pull

    ii.  There may be two reasons for the demand-pull inflation, the increase in the actual or real GDP, or the increase in the money supply in the economy.

   iii.  The velocity of money is the ratio of nominal GDP to the money supply and is a measure of the likelihood of inflationary pressures.

Velocity of Money  = (Nominal GDP) / M2

Where M2 is the measure of money supply in the economy.

   iv.  If the velocity decrease is a result of an increase in the money supply, it may indicate inflationary pressure. However, if it is due to an increase in the Nominal GDP, it may be disinflationary or deflationary.

d.  Some of the measures of the inflation expectations are:

     i.  Extrapolation of trends in inflation

    ii.  Surveys of inflation expectations

   iii.  Comparison of yields on inflation-adjusted securities with non-inflation-adjusted securities