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org

DEFLATIONARY PARADOX IN INDIA

By
Rajesh P
Lecturer in Economics
Govt. Sankrit College
Pattambi.
E-mail: kprajesh@rediffmail.com

This version of the paper has been prepared for presenting at an open seminar
organized by the Interdisciplinary Forum-Multimedia Centre, Govt. Sanskrit College,
Pattambi on 23-07-2009.

(Updated on September 03, 2009)

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DEFLATIONARY PARADOX IN INDIA

By Rajesh P*

I. Introduction

Price instability caused by either inflation or deflation is one of the most thorny problems
encountered by a monetary economy. Inflation is a sustained rise in the general price level or
a persistent decline in the purchasing power of money; deflation is just the opposite and
therefore, indicates a continuous decline in the general price level or a steady rise in the
purchasing power of money. Deflation happens in an economy if negative inflation sustains
over a period of time.

All monetary economies, during certain phases of their development, have experienced mild
or severe bouts of inflation. But, deflation is rarer than inflation, but when it strikes, it causes
destruction all around with falling demand, sluggish investments and widespread
unemployment.

This paper is on deflation in India, a topic of current interest to the public, policy makers and
research community. The current state of inflationary / deflationary condition in India is the
major reason why this theme has been chosen for introspection today. Inflation rate in India
has dived from a thirteen-year high of 12.91 percent during the first week of August 2008 to
three decade low of -1.74 percent during the first week of June 2009 (provisional figure for
the week ended on June 01, 2009). Thus, within a span of just ten months India has witnessed
a very high inflationary as well as deflationary episode.

The current situation however represents a cruel paradox for consumers as prices of essential
commodities continue to rise but the inflation statistics released by the government gives
negative inflation figures which generally imply deflation. What we witness now in India is
the co-existence of a sustained rise in the general price level (reflected in the market and also
in the whole sale price index) or a persistent decline in the purchasing power of Indian Rupee

* Rajesh KP is a Lecturer in the PG Department of Economics at Govt. Sanskrit College, Pattambi, Kerala –

679 306. E-mail: kprajesh@rediffmail.com

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(i.e., inflation) and an official deflation rate (i.e. negative inflation rate). This paradoxical
phenomenon distorts the economic decisions of majority of the economic agents unless they
form rational expectations, which we cannot expect now in a country with mass illiteracy.

Inflation (or deflation) is an economic phenomena that affects every citizen, almost everyday;
and there is much talk of inflation (or deflation) but it is not understood fully, especially its
measurement. The current paradoxical deflationary situation can be attributed to the faulty
measurement of Inflation in India. This paper gives a special focus on the issues in the
measurement of inflation in India along with the analysis of inflationary trends and its current
status.

The remainder of the paper proceeds as follows. The next section critically discusses the
measurement of inflation in India. This will be followed by a review of inflationary trends in
India from the 1950s to the present times in Section III. Then an exploratory analysis on the
current inflationary/deflationary trend is attempted at the end of the section. The concluding
observations along with a few suggestions are presented in the last section.

II. Measurement of Inflation in India

In general, inflation is measured by calculating the percentage rate of change of a price index,
which is called the inflation rate. The price index is an indicator of the average price
movement over time of a fixed basket of goods and services. The general measure of inflation
could be given as:

( Pt  Pt  k )
t  * 100
Pt  k

where, denotes the inflation at time 't', 'Pt' denotes the price index at time 't', and 'k' be the
time lag. The mode of measuring inflation depends on 'k'. There are many possibilities for the
measurement of inflation, viz., annualized/fixed base; annual point-to-point/average, where
the frequency could be annual / quarterly / monthly / weekly for the price index.

Two different price indices are published in India: the Wholesale Price Index (WPI), and the
Consumer Price Index (CPI); and a third type of index viz., the Implicit National Income
Deflator (NID), can be constructed from the national income data. Therefore, inflation rate in
India can be measured in terms of these three indices.
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In India, official inflation (headline inflation 1 ) rate is measured based on annual point-to-
point basis change in the WPI. Wholesale price used in the WPI is the basic (ex-factory/ex-
mining) price of a commodity minus trade discount (if any) plus central excise duty
(including cess).

The existing WPI series in India, with base year 1993-94=100, comprises 435 commodities
classified under the three major groups viz., (i) primary articles (98), (ii) fuel, power, light
and lubricants (19) and (iii) manufactured products (318) with weights of 22.02 per cent,
14.23 per cent and 63.75 per cent, respectively. The total number of price quotations for these
commodities was 1918. The WPI is the weighted arithmetic mean of these group indices
based on the Laspeyre’s formula 2 which has a fixed base-year weighting diagram operative
through the entire life span of the series. Weights used in the WPI are value weights not
quantity weights as they find it difficult to assign quantity weights. The WPI is compiled and
released every week by the Office of the Economic Adviser (OEA) in the Department of
Industrial Policy and Promotion, Ministry of Commerce and Industry. The WPI data is
available on weekly frequency with a lag of two weeks from the date of release for
provisional index and ten weeks lag for the final index. Currently, the OEA releases weekly
WPI inflation every Thursday. As for instance, data released on 03rd September 2009 pertains
to the week ended 22nd August 2009 and the final index published on that day is for the week
ended 27th June 2009. The WPI is only a commodity price index and it does not capture price
changes in non-commodity producing sectors viz. services and non-tradable commodities.

India is the only major country that uses WPI as a measure of headline inflation. Most of the
developed countries use the Consumer Price Index (CPI) to calculate inflation, as this
actually measures the increase in the cost of living. The CPI is a price index that tracks the
prices of a specified basket of goods and services that a typical consumer purchases.

In India, there are four official series on CPI that are specific to different groups of
consumers, viz., CPI for Industrial Workers (CPI-IW) with base 2001, CPI for Urban Non-
Manual Employees (UNME) with base 2001, CPI for Agricultural Labourers (AL) with base
1986-87, and CPI for Rural Labourers (RL) with base 1986-87. CPI-UNME is compiled by
the CSO and the other three CPIs are released by the Labour Beaureau in the Ministry of
Labour. CPI-IW is the most well known of these indices as it is used for wage indexation in
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Government and in the organized sectors. The CPI is available on monthly basis, but with a
lag of one month. The relative merit of CPI in India is that it also cover some basic services,
whereas, WPI is only a commodity price index. Moreover, the CPI is more relevant in
measuring inflation as it measures impact of price changes on households; however, its low
coverage and quality are questioned. Consumer Price Index for Industrial Workers (CPI-IW),
the most commonly quoted of the four CPI measures in India, covers only 260 commodities.
The CPI is a more non-transparent index and this non-transparency has encouraged mistrust
of the CPI and conspiracy theories about manipulation of data by the government. So, while
the CPI fundamentally makes more sense than the WPI, the usefulness of the current series of
CPI in India has been radically undermined owing to low frequency, thin coverage, high
delays and non-transparency. These difficulties with the CPI, inter alia, have led India to use
the WPI for measuring inflation.

One alternative comprehensive measure for inflation comes from the implicit national income
or GDP Deflator 3 . It is derived from national accounts data released by the CSO as a ratio of
GDP at current prices to GDP at constant prices. Since it encompasses the entire spectrum of
economic activities including services, the scope and coverage of national income deflator is
wider than any other measure. At present, the GDP deflator is available only quarterly with a
long lag of two years and hence has very limited use for the conduct of policy.

While each measure of inflation has its advantages and weaknesses, India accepted WPI as its
headline measure of inflation mainly because it has broader commodity coverage, it is
available at high frequency, it is computed at all-India basis, and moreover, there is no other
representative retail price index or consumer price index at such regular high frequency.
Consequently, the “headline inflation number” widely followed has become the WPI and
which enables continuous monitoring of the price situation for related policy interventions.

The measurement of inflation using WPI frequently produces unrealistic results as the
ongoing WPI series in India suffers from a number of defects. The WPI does not properly
measure the exact price rise an end-consumer will experience because, as the name suggests,
it is calculated at the wholesale level, and more over, the services¸ which have assumed so
much importance, do not come under the ambit of WPI. In fact, service sector forms an
essential part of the consumption of everyone in the country, and which currently accounts
for more than 52 percent of Indian GDP. More over, given the use of the Laspeyre’s formula
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with fixed weighting diagram, particularly in the absence of frequent base year revisions,
WPI fails to capture the structural changes undergoing in an economy at a rapid rate. The
changes in the consumption pattern of people and the qualitative changes in the basket of
commodities are not getting reflected in the WPI. For instance, not many people were using
cell phones in 1993-94 but are using them extensively now. An index that does not take into
account the changing prices of mobile services will not be relevant in today’s context. At the
same time, many commodities not consumed by consumers get calculated in the index.
Moreover, the WPI is not able to adjust the price increase of commodities to its quality
improvement.

It is pertinent to note that the annual point-to-point inflation, which is used in India, is
susceptible to the base effect 4 . To be more specific, if there were abrupt price variations and a
relatively very high price index one year earlier, its effect would be reflected in the current
inflation rate, though the current price level may be very stable. To illustrate it, note that the
WPI for the week ended 1st August 2009 rose by 0.13 percent to 237.2 (Provisional) from
236.9 (Provisional) for the previous week (25th July 2009). But the annual inflation rate fallen
to -1.74 for the week ended 01st August 2009 from 0.13 for the previous week, which is 0.16
percentage points lower than the rate for the previous week. To make it clearer, now let us
verify how the base effect has resulted in a deflation rate of -1.74 in the first week of August
2009; now compare an abrupt 0.29 percent increase in WPI during the last week of July and
first week of August in the last year (2008) to a relatively negligible 0.13 percent increase in
the index during the corresponding weeks in the current year (2009) resulting in deceleration
of inflation rate at a period of accelerating WPI. This is a clear example of base effect. The
recent deflationary episode is attributed to a high base effect, which creates deflationary rates
during an inflationary period.

It is high time that India abandoned WPI and adopted a modified single CPI to calculate
inflation on monthly or fortnightly basis. But India is not switching over to the CPI method of
calculating inflation; the official justifications for continuing with the WPI measure are: (i)
the problem of selecting one from the four different types of CPI indices, and (ii) too much
lag and low frequency of reporting the CPI numbers. These problems can be solved if India
could start computing a fresh series of a single overall measure of CPI at all-India basis on
weekly intervals.
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Inflation measures are often modified over time, either for the relative weight of goods in the
basket, or in the way in which goods from the present are compared with goods from the past.
A new Working Group has been constituted under the Chairmanship of Prof. Abhijit
Sen, a Planning Commission member from Jawaharlal Nehru University, for the revision of
the current series of WPI. As per the recommendations of the Working Group a new WPI
series, with a revised base year of 2004-05, is expected to come into effect very soon. The
Product Basket of the new series proposed by the Working Group comprises of 1,224
products, compared to 435 products in the existing series. The number of products in case of
Primary Articles would rise marginally from 98 to 105, and in the case of ‘Fuel, Power, Light
& Lubricant’ group the number of products would remain unchanged at 19. The commodity
basket in the case of manufactured products would have a jump from 318 products to 1100
products, an increase of 245.9 percent. The panel has decided to increase the weight of
manufactured items and the fuel group in the new index. The weight of manufactured items
goes up to around 64.97 per cent from 63.75 per cent in the present series. The fuel group
weight will increase to around 14.91 per cent, from 14.23 per cent. The weight of primary
articles will decrease from 22.03 per cent to around 20.11 per cent, reflecting changing
production and consumption patterns in the economy. In all, price quotations from all
commodities are being increased to around 6,000 from 1,918.

III. INFLATIONARY TRENDS IN INDIA

3.1 A Decadal Comparison of Inflation Rates in India

In this section, a review of inflationary trends in India for the last nearly six decades is
presented. The data required for the analysis in this section is collected from the Office of the
Economic Advisor, Ministry of Commerce and Industry, Government of India, Reserve Bank
of India (RBI), Labour Beaureau, Ministry of Labour, and Central Statistical Organization
(CSO). The average inflation rate (based on WPI) over the past six decades averaged 6.4
percent per annum. The decade-wise annual average inflation rate along with corresponding
range is presented in Table 1. The annual average inflation rate during 1950s was very low at
1.7 percent. The minimum inflation at a negative rate in 1952-53 was in response to the
bumper agricultural production in that year while the maximum inflation rate in 1956-57 was
mainly attributed to demand pressures, especially investment demand.
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The average annual inflation accelerated steadily to 6.4 per cent during the sixties. The Indo-
Chinese War in 1962, the Indo-Pakistan conflict in 1965, and the consequent increase in
defense expenditure and unsatisfactory supply position were responsible for the mounting
inflationary pressure during the 1960s. . The famine conditions during 1965-66 aggravated
the situation further. The minimum inflation rate of -1.1 per cent in 1968-69 was attributed
primarily to the bumper agricultural production in the preceding year.

Table 1
Decade-wise Annual Average Inflation Rate in India (1950s to 2000s)
Sl. Average Minimum Maximum
Decade
No. Inflation Rate* Value Year Value Year
1 1950s 1.7 -12.5 1952-53 13.8 1956-57
2 1960s 6.4 -1.1 1968-69 13.9 1966-67
3 1970s 9.0 -1.1 1975-76 25.2 1974-75
4 1980s 8.0 4.4 1985-86 18.2 1980-81
5 1990s 7.8 3.3 1999-00 13.7 1991-92
6 2000s# 5.2 3.4 2002-03 8.2 2008-09
#
Note: *Based on the annual variation in WPI; Up to 2008-09.
Source: Office of the Economic Adviser, Ministry of Commerce and Industry, Government
of India

During the seventies, the annual inflation rate increased further to 9 percent. The maximum
inflation annual inflation rate of 25.2 per cent recorded in the year 1974-75 was mainly
attributed to the widespread failure of Kharif crops in 1972-73 as also to the hike in crude oil
prices in 1973. The substantive anti-inflationary measures taken by the government brought
the inflation down to -1.1 percent in 1975-76.

The decadal average inflation moved down marginally to 8.0 per cent during the eighties. The
highest inflation rate for the decade was at 18.2 per cent in 1980-81. The poor agricultural
production and the resultant adverse industrial performance along with the oil price hike
resulted in such a price hike.

During the nineties, the average inflation rate decreased marginally to 7.8 percent per annum.
The first half of the nineties witnessed a sharp increase in inflation. The oil price hike and
loss of remittances following the Gulf-war, and large-scale monetization of fiscal deficits
were the important reasons for the acceleration of inflation in this period. However, the
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second half of the nineties was marked by a significant deceleration in the inflationary trend.
Favorable agricultural performance along with the macro-economic stabilization measures
adopted by the Union government has resulted in the turnaround in the inflation outcome.

Figure 1
Decade-wise Annual Average Inflation Rate in India
(1950s to 2000s)

10
9
9
8 7.8
8

7 6.4
Inflation Rate (%)

6
5.2
5

2 1.7

0
1950s 1960s 1970s 1980s 1990s 2000s*
Decade

Average Inflation Rate

The annual average inflation for the first eight years of the current decade (i.e., from 2001-02
to 2008-09) is 5.2 percent. The supply side factors have been more instrumental in
moderating the inflationary trend during this period.

India uses WPI to gauge the headline inflation in the country, this can however be justified
only if it is a reliable predictor of the CPI inflation. We need to verify empirically whether the
WPI inflation is a good predictor of CPI inflation. Figure 2 presents the inflationary trend on
the basis of the three indices viz. WPI, CPI-IW, and GDP Deflator. The figure reveals that
there have been leads and lags involved during certain phases, which tend to get evened-out
over long time spans, but there has not been any secular or systematic bias.

From a long-term perspective, however, inflation as measured in terms of WPI and CPI-IW
and GDP deflator seems to be converging. General converging of overall indices, measuring
changes in prices notwithstanding their year-on-year variations, indicates a strong association
in inflation rates, both in its acceleration and deceleration phase across all these indices.
(Figure 2). Our analysis of long term time-series data of the three indices for a period from
1971-72 to 2007-08 shows a very high and statistically significant positive cross-correlation
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between the inflation rates based on the three indices 5 . This indicates that WPI is not a poor
predictor of CPI in India in the long run.

Figure 2
Inflationary Trends in India (1971-'72 to 2008-09)
A Comparision of Different Indicators

30.0

25.0

20.0
Inflation Rate (%)

15.0

10.0

5.0

0.0
1971-72

1973-74

1975-76

1977-78

1979-80

1981-82

1983-84

1985-86

1987-88

1989-90

1991-92

1993-94

1995-96

1997-98

1999-00

2001-02

2003-04

2005-06

2007-08
-5.0

-10.0
Year

WPI CPI-IW GDP-Deflator

Sources: 1. Office of the Economic Adviser, Ministry of Commerce and Industry,

Government of India
2. Labour Bureau, Ministry of Labour, Government of India.
3. Central Statistical Organisation

3.2 The Current Status

The inflation rate in India had been stable and lower towards the end of the year 2007; the
annual point-to-point inflation rate was 3.8 on December 29, 2007. An inflationary spurt had
started in the beginning of the year 2008 and it reached its peak by the first week of August,
2008 (12.91%), and then it dipped to its bottom by the last week of May 2009 (0.13%), and a
deflationary phase has been started in first week of June 2009. Thus, in terms of inflationary
experience, the year 2008 was an extraordinary one, for it has witnessed an inflationary cycle
with steady inflationary trend in the first eight months and a sustained disinflationary trend in
the remaining four months, the year 2009 is unique one as it has witnessed a deflationary
phase after three decades.
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Figure 3
Weekly Movements of Annual Inflation Rate (Point-to-Point) in India
(January 2008 to August 2009)

14.00

12.00

10.00

8.00
Inflation Rate (%)

6.00

4.00

2.00

0.00
5/1/2008

26/01/2008

16/02/2008

8/3/2008

29/03/2008

19/04/2008

31/05/2008

21/06/2008

2/8/2008

23/08/2008

13/09/2008

25/10/2008

15/11/2008

27/12/2008

17/01/2009

7/2/2009

28/02/2009

21/03/2009

2/5/2009

23/05/2009

13/06/2009

4/7/2009

25/07/2009

15/08/2009
10/5/2008

12/7/2008

4/10/2008

6/12/2008

11/4/2009
-2.00

-4.00
Date

Inflation Rate (%)

Source: Office of the Economic Adviser, Ministry of Commerce and Industry,

Government of India

The weekly movements in the annual point-to-point inflation are given in Figure 3. As can be
observed from the figure, the rate of inflation based on WPI was moderate at 4.3 in beginning
of January, 2008, but it sharply increased to 7.8 by the end of March and mounted to its peak
12.9 percent by the first week of August, 2008, the highest figure in the last 13 years. Then
the inflationary trend reversed and the price movements have shown a steady and marked
deceleration; it came down to 5.9 per cent by the end of the last week of December 2008 and
again to 0.13 percent by the last week of May 2009. Thus, during the first seven-month
period of 2008, the inflation rate increased by 8.6 percentage points; on contrary in the next
nine months the rate declined by 12.78 percentage points. By the first week of June 2009,
India's annual headline inflation rate slipped into negative territory (-1.01%), the deflation
rate peaked to -1.74 by the first week of August and the deflationary trend continues as per
the data available till date. Thus, after more than three decades India is experiencing a
statistical deflation. Inflation figures in India had last turned negative in 1977.
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The most important reason for the inflationary upsurge in the first half of 2008 was the
alarming rise in the world crude oil prices and the resultant increases in the retail fuel prices
in India and its cascading effect on all food commodities and other manufactured items,
particularly consumer durable goods and steel. In addition to that a supply-demand mismatch
in food grains, pulses, and edible oil in India and all over the world also had significantly
contributed to mounting inflationary spiral in the country. The rising world food prices are
attributed partially to the diversion of food to fuel 6 .

The inflationary cycle in India is shaped to a great extent by external forces such as the
excessive fluctuations in the global crude oil and commodity prices. The ongoing global
financial crisis and the resultant decline in the international petroleum prices have a
significant role in the marked deceleration of inflation rate in India since September 2008.
Moreover, decline in the domestic and international demand for goods and services also has
pulled down the prices in India.

Now it is intriguing to explore the reasons for the recent deflation episode in India. Deflation
is generally unwelcome by policymakers as it encourages consumers to delay purchases and
businesses to postpone investment, which would eventually create unemployment and hurt
GDP growth. This fall in the inflation rate to negative figures is only an interesting statistical
set of numbers. This is mainly due to a high statistical base effect, which has pulled the
inflation number down and it was entirely expected. The recent statistical deflation does not
reflect an actual contraction in the prices.

The overall index (i.e., WPI) started increasing from the first week of March 2009, and has
increased by almost 5.7% since then, clearly showing rising price level or real inflation. But it
is sardonic to realise that the official inflation figures started falling by the last week of April,
2009 and became negative by the first week of June 2009. This paradoxical phenomenon,
created by the base effect, can be visualised from Figures 4 and 5. The figures clearly show
that inflation rates are declining during a period of persistent rising WPI. This apparently is
due to the fallacies of the base effect. It is useful to note that, the consumers are affected by
the actual price level (i.e., WPI) and not inflation rate.

Figure 6 reveals the inflationary situation in terms of CPI-IW. It clearly shows that there is no
significant fall in the inflation rate for the consumers.
 Inflation Rate (%) WPI

228
230
232
234
236
238
240
242

-2.00
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
25/04/2009
25/04/2009
2/5/2009
2/5/2009

9/5/2009
9/5/2009

16/05/2009
16/05/2009

23/05/2009
23/05/2009

30/05/2009
30/05/2009

6/6/2009
6/6/2009

13/06/2009 13/06/2009

20/06/2009 20/06/2009

Date

Date
27/06/2009 27/06/2009
Figure 4

4/7/2009 4/7/2009

Figure 5
11/7/2009 11/7/2009

18/07/2009 18/07/2009

25/07/2009 25/07/2009
Movements of Wholesale Price Index (May 2009 to Ausust 2009)

1/8/2009 1/8/2009

8/8/2009
8/8/2009

15/08/2009
15/08/2009
Weekly Movements of Inflation Rate Inflation Rate [May 2009 to August 2009]

22/08/2009
22/08/2009
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WPI

Inflation Rate (%)

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Figure 6
Movements of CPI-IW Inflation Rate (%)

12

10.45 10.45 10.45

10 9.77 9.7 9.63

9.02
8.7 8.63
8.33
7.87 8.03
7.81 7.75 7.69
8
CPI Inflation Rate (%)

6 5.51 5.47

0
08

09

9
08

08

08

08

09
8

8
-0

-0

-0

-0

-0
r-0
r-0

l-0

-0

-0
g-

p-

n-
n-

b-
b-

n-

ec

ay
ar

ay

ar
ov
ct
Ju
Ap

Ap
Fe
Fe

Ja
Ja

Ju

Au

Se

O
M

M
M

D
Month N

CPI Inflation Rate (%)

The current statistical deflationary phase is unlikely to remain long and create any major long
term impact on the economy. Nonetheless, this statistical phenomenon may confuse some
economic agents and the common man and distort their decision making in the short run,
unless they form rational expectations.

Even though it is no less accurate to ascribe the origins of the recent real price fluctuations in
India to external forces, these external impulses may not be corrected externally. In fact, if
we have a domestic inflation/deflation problem we will have to rely on domestic stabilisation
policy measures.

To ensure price stability, the Indian policy-makers have announced certain conventional
fiscal and monetary policy measures. During the mounting inflationary phase, as part of the
fiscal measures, the government has reduced excise and custom duties on key products like
crude oil, petroleum products and steel. The government also has scraped import duty on a
number of essential commodities. During the disinflationary phase, the government has
adopted an expansionary fiscal policy through the recent budget.

As part of the monetary policy measures, the Indian monetary authority, Reserve Bank of
India (RBI), had tightened the Cash Reserve Ratio (CRR) 7 and Repo Rates 8 in three
consecutive phases to control the commercial banks’ credit expansion in the economy during
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the recent inflationary phase. During the recent disinflationary phase the RBI has drastically
slashed CRR, Repo Rates, and Reverse Repo Rates in a phased manner since October last
year. However, the policy measures have been mystifyingly inadequate to ensure price
stability ion the economy.

IV. CONCLUDING REMARKS

India, the 12th largest and the second fastest growing major economy in the world, has been
experiencing significant price instability in the recent past. Even though, the sources of the
phenomenon can be attributed to both internal as well as external factors, correction of the
problem will have to take place mainly though effective domestic economic policies for both
the demand management and supply adjustment. But the domestic policy measures initiated
in India have not seen bringing any significant effects in controlling price volatility in the
country.

It is also an appropriate time to critically think about the quality of the official inflation
statistics published in India. No single price index will be able to provide a measure inflation
that can be used for all the purposes. Five official price indices are published in India, of
which one is WPI and the other four are CPIs. All the five indices suffer from some inherent
deficiencies. The most common deficiencies include importantly the fact that our compilation
procedures neither systematically incorporate new goods and services as they enter the
market nor adjust for changes in the quality of goods and services over time. Consequently,
our price indices could not be used to gauge inflation in the economy.

Our headline inflation measure, WPI, is extremely inadequate to track the inflationary
pressure in the economy for it excludes services, and it is more susceptible to the problem of
base effect. Moreover, it does not adequately reflect the expansion and quality improvement
of commodities. Therefore, the reported inflationary situation in India, determined using the
WPI, is unreliable to a great extent. In the absence of a reliable measurement of inflation it is
difficult to analyze the exact impact of the inflation/deflation and announce appropriate
policies to ensure price stability. It is high time for India to revise the method of calculating
price index and inflation measurement so as to enable a proper and periodic assessment and
control of inflation in the economy. It would be desirable to take into consideration the
following points while preparing a price index and measuring inflation in India 9 .
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Firstly, the current headline inflation measure, WPI, should be replaced with a newly
constructed comprehensive and aggregate broad based CPI or a cost of living index, and
which should be made available fortnightly or monthly. Inclusion of more services in the
index will give a true picture of inflation in India as the service sector accounts for more than
half of the GDP in India. More over, the new CPI should be made transparent in terms of its
content.

There seems to have a trade-off between the frequency and reliability of the inflation figures.
More frequent data are said to be less reliable data. Therefore, it is desirable to changeover to
a less frequent (fortnightly or monthly) and more reliable index in line with the standard
practice in other countries.

Secondly, the method of index calculation should accommodate quantitative and qualitative
changes in the commodity basket; the method should systematically incorporate the entry of
new commodities and services and also the exit of some old commodities and services in the
calculation of the index.

Thirdly, the current measure WPI should be modified or replaced (not for measuring headline
inflation, but to provide a better the producer price index) to incorporate services and also
more commodities in it.

Fourthly, a de-seasonalised price index should be used for measuring month-over-month but
annualized inflation rate, which is free from the base effect.

Finally, a better method of index construction, such as Fisher’s Ideal Index should be used
replacing the Laspeyres Index for the construction of all price indices. The indices have to be
revised periodically to capture the more dynamic segments of the economy.

However, the long run solution to the real inflation/deflation problem does not lie in the
revision of the method of its measurement; it rather depends on the appropriate supply
adjustment and demand management measures. Therefore, the government should formulate
appropriate economic policies to provide incentives to ensure adequate domestic production
and stabilize domestic demand for commodities and services in the country.
 http://vijnanacintamani.org

SELECT BIBIOGRAPHY

Balakrishnan, P (1991), Pricing and Inflation in India, Oxford University Press, Delhi.

Batura, N. (2008), ‘Understanding Recent Trends in Inflation, Economic and Political

Weekly, Vol. XLIII, No. 24, pp. 108–111.

Central Statistical Organisation, National Account Statistics, Various Issues.

Gordon, R (2006), ‘The Boskin Commission Report: A Retrospective One Decade Later’,
Working Paper 12311, National Bureau of Economics Research, Cambridge, MA.

Government of India (2009): Economic Survey 2008-09, New Delhi.

Mishra, AR and S Zarabi (2008), ‘Inflation Pays the Price of Poor Data Collection’, Business
Standard, May 15, Mumbai Edition.

Mohanty, D., Rath, D. and M. Ramaiah (2000), ‘Measures of Core Inflation for India’,
Economic and Political Weekly, ol. 35, No. 5, pp.273-82.

Reserve Bank of India (2007), Report of the Internal Technical Group on Seasonal
Movements in Inflation, Reserve Bank of India, Mumbai.

Reserve Bank of India (2008a), Macroeconomic and Monetary Developments in 2007-08,

Reserve Bank of India, Mumbai.

Reserve Bank of India (2008b), Handbook of Statistics on Indian Economy, Mumbai.

Reserve bank of India, RBI Monthly Bulletin, Mumbai, Various Issues.

Samantha G and S. Mitra (1998), ‘Recent Divergence Between Wholesale and Consumer
Prices in India – A Statistical Exploration’, RBI Occassional Papers, Vol. 19, No.4,
December.

Srinivasan, TN (2008) ‘Price Indices and Inflation Rates’, Economic and Political Weekly,
Vol. XLIII, Nos. 26 and 27, pp. 217–223.

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 http://vijnanacintamani.org

Notes
1
Headline inflation is a more broad measure of inflation that includes those areas of the market that may
experience volatile price movements, where as Core inflation is a measure of inflation that excludes certain
items that face volatile price movements.

2 Laspeyres Price Index is a weighted aggregate price index, where the weights are determined by quantities in
the base period. The formula used for constructing the index (i.e., WPI) in India is:

 I i .W i
I 
Wi

I= Index Number of wholesale prices of a commodity or a commodity group [={Pt / P0}.100] where Pt is the
price in period t and P0, that in the base period of the concerned commodity/commodity group.

Wi = the weight assigned to the ith item/sub-group/group/major group = P0.Q0/ΣP0.Q0, i.e. expenditure in the
base period evaluated at base year prices for the ith commodity as a proportion of total expenditure also
evaluated at base year prices.

The commodity index is arrived at as the simple arithmetic average of the price relatives of all the varieties
included under that commodity. The indices for the sub-groups/groups/major groups/all commodities are, in
turn, worked out as the weighted arithmetic means of the indices of the items/sub-groups/groups/major groups
falling under their respective heads.

An interesting property of Laspeyres index is that it is generally expected to overestimate or to leave an upward
bias.
3
The GDP Deflator is the most comprehensive measure of inflation as it reflects the price of all the goods and
services included in Gross Domestic Product (GDP). It is the ratio of nominal GDP to the real GDP multiplied
by 100. That is

No min al GDP
GDP Deflator  * 100
Re al GDP

4
Refer Reserve Bank of India (2007) for a detailed description.
5
The estimated Personian Correlation Coefficient between WPI and CPI-IW, WPI and GDP Deflator, and CPI-
IW and GDP Deflator are 0.998, 0.999, and 0.999 respectively. All the values are significant at less than one
percent level.
6
For instance, in counties like the US food crops like corn are used for making ethanol.
7
Cash reserve Ratio (CRR) is the proportion of funds that the banks have to keep with RBI. If RBI increases its
percentage, the available amount with the banks will come down. Currently CRR is 5 percent.
8
Repo rate is the rate at which commercial banks borrow money from RBI. When the repo rate increases, the
borrowing from RBI becomes more expensive. At present the repo rate is 4.75 percent and reverse repo rate is
3.25 percent.
9
Some useful proposals for reforming the Indian price indices are available in Srinivasan (2008).

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