Inflation - How do we measure it?
In the last post, I described that inflation is nothing more than the strength of the currency. In the previous post, I used a cross currency reference of Australian Dollar and US Dollar to describe the relative purchasing power of Australians vs Americans. In this post, I will describe the relative strength of currency between two time periods at the national level.
In order for one to measure the strength of the currency in the domestic land between two time points, following parameters are needed:
a) Starting time point (usually denoted as t0 and often referred as reference point)
b) Future time point (any time in future, when inflation needs to be measured)
c) An Underlying(s) whose price needs to be measured usually called commodity basket or just basket.
Now, in order for us to measure the strength of the currency, we should take a good sample of products that can help represent the inflation accurately.
Let's say a regular consumer has a dependency on following products
1. A gallon of Milk
2. A gallon of Gasoline
3. A 2 Litre bottle of Coke
4. A 32 inch television
I am taking a very small sample to get the point across but you can imagine that governments must consider all sorts of products that can accurately represent the domestic economy such as price of chicken, train ticket to New York City from Boston and so on.
Now, the above 4 products called the basket and their price is called Basket price. Imagine, our reference point is 2012 and hence we need the price of this basket on Jan 1, 2012 and Jan 1, 2013.
For simplicity, I am assuming uniform weights of these commodities in the economy and assuming that these 4 products accurately represent the economy.
Item Jan 1, 2012 Jan 1, 2013
Milk $5.00 $4.50
Gasoline $2.75 $3.20
Coke $2.00 $3.50
TV $100.00 $101.00
===============================
Basket $109.75 $112.20
Price
===============================
So, the basket is 2.23% more expensive on Jan 1, 2013 when compared against same products on Jan 1, 2012. This will be known as yearly inflation.
Basket price is also known as Price index. In United States, it's called CPI (Consumer Price Index) where Index means the basket price of a bunch of commodities that US Govt uses as a reference basket to accurately represent health of economy.
Governments don't like higher inflation because it makes their currency weaker on a relative scale basis and hence they would intervene at various levels to control the relative strength of the currency.
Governments control inflation due to following 2 simple facts:
1. When currency becomes very expensive, exports takes a beating because the currency becomes very expensive for outsiders.
2. When currency gets cheaper, importers take a huge beating and these prices need to pushed down to the end consumer and consumers don't like to pay higher prices.
That's it for tonight.
Nitin
In the last post, I described that inflation is nothing more than the strength of the currency. In the previous post, I used a cross currency reference of Australian Dollar and US Dollar to describe the relative purchasing power of Australians vs Americans. In this post, I will describe the relative strength of currency between two time periods at the national level.
In order for one to measure the strength of the currency in the domestic land between two time points, following parameters are needed:
a) Starting time point (usually denoted as t0 and often referred as reference point)
b) Future time point (any time in future, when inflation needs to be measured)
c) An Underlying(s) whose price needs to be measured usually called commodity basket or just basket.
Now, in order for us to measure the strength of the currency, we should take a good sample of products that can help represent the inflation accurately.
Let's say a regular consumer has a dependency on following products
1. A gallon of Milk
2. A gallon of Gasoline
3. A 2 Litre bottle of Coke
4. A 32 inch television
I am taking a very small sample to get the point across but you can imagine that governments must consider all sorts of products that can accurately represent the domestic economy such as price of chicken, train ticket to New York City from Boston and so on.
Now, the above 4 products called the basket and their price is called Basket price. Imagine, our reference point is 2012 and hence we need the price of this basket on Jan 1, 2012 and Jan 1, 2013.
For simplicity, I am assuming uniform weights of these commodities in the economy and assuming that these 4 products accurately represent the economy.
Item Jan 1, 2012 Jan 1, 2013
Milk $5.00 $4.50
Gasoline $2.75 $3.20
Coke $2.00 $3.50
TV $100.00 $101.00
===============================
Basket $109.75 $112.20
Price
===============================
So, the basket is 2.23% more expensive on Jan 1, 2013 when compared against same products on Jan 1, 2012. This will be known as yearly inflation.
Basket price is also known as Price index. In United States, it's called CPI (Consumer Price Index) where Index means the basket price of a bunch of commodities that US Govt uses as a reference basket to accurately represent health of economy.
Governments don't like higher inflation because it makes their currency weaker on a relative scale basis and hence they would intervene at various levels to control the relative strength of the currency.
Governments control inflation due to following 2 simple facts:
1. When currency becomes very expensive, exports takes a beating because the currency becomes very expensive for outsiders.
2. When currency gets cheaper, importers take a huge beating and these prices need to pushed down to the end consumer and consumers don't like to pay higher prices.
That's it for tonight.
Nitin
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