Some of you would have realised that in the China virus season the supermarkets have raised prices and stopped offering discounts on many goods. As a result you would have experienced rising food bills which according to layman knowledge should translate into inflation*. At the same time, you may have read many economists predict a period of recession, deflation** and high levels of unemployment. So how is it that when you are experiencing inflation personally, economists predict the existence of deflation?
It all depends on the way the inflation rate is calculated.
The UK government uses the Consumer Price Index (CPI) to estimate the inflation rate in the British economy. It works like this:
1. Every year a few thousand families are asked to record their expenditure for a month. From this data the indexers estimate the types of goods and services bought by an average household and the quantity of their income spent on these goods.
2. With this information, surveyors are sent out each month to record prices for the above mix of goods. Prices are recorded in different areas of the country as well as in different types of retail outlets. These results are averaged out to find the average price of goods and this is converted into index numbers.
3. Changes in the price of some goods are considered more important than others based on the proportion of the income spent by the average household. This means that the above numbers have to be weighted before the final index is calculated.
---Topics covered earlier
---
Consider this example:
Assume that there are only two goods in the economy, food and cars. The average household spends 75% of their income on food and 25 % on cars. Suppose there is an increase in the price of food by 8% and of cars by 4% annually.
In a normal average calculation, the 8% and 4% would be added together and divided by 2 to arrive at an average inflation of 6%
However, this provides an inaccurate figure because spending on food is more important in the household than spending on cars. Food is given a weight of 75% and cars are given a weight of 25%. So the price increase of food is multiplied by ¾ (8*3/4 = 6) and added to the price increase of cars which is multiplied by ¼ (4*1/4 =1) which will result in an inflation of 7%.
Therefore if the inflation index was 100 at the start of the year then it will read 107 at the end of the year.
The accuracy of inflation calculations
As the example makes clear this calculation is based on an imagined average family’s spending patterns. There maybe only a few families in the UK that have the exact same spending patterns as imagined by the government.
Theoretically, different rates of inflation could be calculated within an economy by changing the consumption patterns or weightings in the index. This will explain why the inflation that you experience may be higher or lower than the government’s inflation rate.
* Inflation is an average increase in price level compared over a previous period.
** Deflation is an average decrease in price level compared over a previous period.
Disinflation means the inflation in the current period is lower than the earlier period.