Calculating Inflation and its relation with the Currency

Calculating Inflation and its relation with the Currency

It had been a month since I joined IIM Kashipur to pursue my MBA and I was loving this place already. Hostel life was a completely new experience for me. The fact that tourist attractions like Jim Corbett Park, hill station of Nainital are an hour away from the institute was fascinating. This was the first time I had moved out of Mumbai, away from my family, but technologies such as Skype helped me to break the geographical barriers to great extent.  It was time for me to keep my promise on the deal that I had struck with Apurva and have the weekly Skype session to answer her questions. After the discussion about my life at IIM Kashipur, we started the discussion where we had left.

“Before you tell me the relation between the currency and the inflation, I have been wondering all this while as to how RBI calculates the inflation and concludes whether it is high or low ?”,asked Apurva.

“RBI uses an Index called as Wholesale Price Index (WPI) to calculate inflation”, I started explaining her. It is an index build with the prices the wholesalers have to pay to the manufacturer. This index is an indicative figure whose value can be compared with previous time period such as previous month or previous year. In WPI there are more than 650 goods and commodities whose wholesale price is tracked. These commodities are divided in three main categories which are

1. Primary Articles         2. Fuel and Power           3. Manufactured Products.

These three categories are given weight as per their influence in day to day life of a common Indian Man. Primary Articles are given 20% weight while Fuel and Power are given 15% and Manufactured Products are given 65% weight. Each of these categories have many items with the weight distributed among the category. And as with every index there is a base year whose value is considered to be 100 and new value of index would be calculated based on the base year value. For WPI year 2004 is considered to be base year with the value of 100. Let me explain this with the help of an example. For simplicity, assume there are only three items that existed: Milk, Oil and Sugar.

WPI_Calculation_Simplified

So as per the calculation the WPI inflation is 8.57%. The WPI inflation number is available weekly every Thursday with two weeks of delay. WPI is the main index which is followed by RBI as to decide whether the inflation is in control or not. Apart from WPI, RBI also looks for a Consumer Price Index (CPI) which is a price index calculated based on the prices which end consumers pay to the retailers. This index indicates actual inflation in the hands of consumer and not just for the wholesalers.

“RBI would want WPI inflation to be 0% or even negative, right?” asked curious Apurva. “Not really”, I started explaining her. RBI would want this to be around 3-4% ideally on the consistent basis. RBI also needs to keep a check on the CPI along with WPI. If inflation is 0% then the total output would not grow and working population would not get their promotions and salary hike. We cannot allow the inflation to go beyond a particular bracket because the salary hikes are not consistent for all, i.e. Income is not uniformly distributed while the increased expenditure is! The rich people of the society can afford the inflation but poor people will not be able to afford it as their income levels have not increased compare to increase in the inflation.

                 

“Now that I understand how inflation is calculated can you please tell why the change in the currency would lead to inflation? I mean, why would change in the currency value would increase the price of the goods and commodities?

“It would be unfair to say that the price of the commodities and goods change if there is a change in the currency but it certainly impacts the inflation”.  Let us take an example,Suppose on 1^st of January 2014, 1$= ₹50. Suppose you want to order an iPhone 6 plus from USA since it has yet not been launched in India.Assume that an iPhone 6 plus costs $1000. The US retailer selling the iPhone to you would prefer the payment in $ as USA has currency of $. So you have to pay  ₹ 50000 typically to a Bank or an institution which is into the currency exchange business and buy $1000 and buy the iPhone 6 plus. 2 days after the purchase on 3^rd of January 2014, you show this iPhone to your best friend and now she also wants a similar phone but on 3^rd of Jan 1$= ₹ 60. The iPhone price is still $1000 but now to buy $1000 you have to give ₹ 60000. Even though the price of iPhone stayed $1000 you still experienced inflation. This is because the purchasing power of Indian Currency has reduced.  That is why when the 1$ value changes from  ₹ 50 to  ₹ 60 we say that Indian Rupees has depreciated as the currency cannot buy as much as it could earlier and we say that $ has appreciated because it take more Rupees to purchase similar amount of $.

“I now understand the how inflation is calculated and relationship between the currency and inflation but why does the value of 1$ change?” asked Apurva. "There are many factors that govern the movement of the currency, let us discuss them next time,when we have the Skype session”, I told her. It was already 11.30 in night but like all others studying in IIM, day had just begun, I thought.