August 23, 2014

Measurements of Inflation

Many economic observers had encountered the term inflation, and that most would associate it to prices. The thinking was very true, yet, few would know that inflation can be measured in different ways using three main price index; and that no single index is considered accurate.

Here are the three main price index used in measuring inflation:

  1. GDP Deflator
  2. Consumer Price Index (CPI)
  3. Producer Price Index (PPI)

GDP Deflator is the ratio of nominal Gross Domestic Product (GDP) to real Gross Domestic Product in a given period. Nominal GDP is the income of the country which is not adjusted to inflation while real GDP is adjusted to inflation. For example a person earn P2,000.00 today (year 2014) – that is the nominal GDP. Then it was adjusted to inflation using year 1990 as base year; in question, what is the value P2,000 in 1990? It turns out that the value was P1,500.00 – this is the real GDP. The example provided was looking at GDP in micro-level. The base year was chosen relative to the stability of prices.

The basic principle of inflation is that your Peso today is not the same as your Peso last year. That is why it is important that GDP is adjusted in real terms, remove the impact of inflation, so that numbers can be analyzed without biased. In the example above, if the income was not adjusted to inflation, the person might think that his income has the same worth as year 1990. Or in macro-level sense, the economic observers might think that production of goods and services has grown; while the truth was, prices of goods were the ones who were increasing.

On the other side, CPI is measured using set of goods which are typically inside the basket of a city consumer. The difference of GDP Deflator from CPI is that the former measures the economy wide prices of goods while the latter measures only a set of goods in a basket. GDP Deflator's set of goods change over time while CPI has fixed number of goods that serve as indicator of prices.

PPI is one of the widely used price index. CPI and PPI has a similarity, both are using the market basket as indicator; the difference is in the content of the basket. CPI's basket contains final goods, in retail level, which are commonly seen in sari-sari stores, grocery, and the likes. PPI's basket, on one hand, are raw products; e.g. wood, copra, corn, and the likes, these products are not yet processed.

Understanding inflation, how it is measured, is very important in balancing the economy.

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