Consumer price index - Measurement rate of inflation

Inflation is inevitable in the booming Indian economy and we have to accept the fact. In simple words, “inflation is a general increase in the level of prices over a period.” Inflation is measured by Consumer Price Index or CPI.

Consumer Price Index shows changes in prices between two periods of standard package of goods and services which Indian household purchases for consumption. Government of India compiles and publishes CPI every month. CPI is comparison between two periods and has a compounding effect. Following table indicates how the consumer prices have changed from the year 2001 to 2011.

The table shows that what was purchased in the year 2001, the cost of same things was Rs. 197 in the year 2011 which means that the cost of living over a period of 11 years had almost doubled or the purchasing power of a Rupee became half. If the income level of a person in 2001 and 2011 was the same, it must have been very difficult for him to meet both ends meet.

Following factors are responsible for inflation in the economy.

Demand Factor

When the aggregate demand in the economy exceeds the aggregate supply, prices of commodities in short supply increase. This happens during a period of draught when supply of some agriculture produces is less than the demand. This could also happen when supply of essential manufactured goods is suddenly reduced for whatsoever reasons. Consumers have to pay more for goods in short supply. This is prominently seen in housing and real estate sector as demand for houses is more than supply and buyers are ready to buy a flat anywhere at any price. This phenomenon is popularly known as “too much money chasing too few goods.”

Supply Factor

Key ingredient for rising inflation is increase in cost of production. If the cost of inputs in agriculture increases, price of food grains go up. In manufacturing sector, when cost of raw materials, labour and other operating costs increase, cost of finished products also increase and the consumer has to pay higher price. When governments raise salaries and pensions of their employees, additional taxes are levied to mop up the costs and goods and services become costlier. Hoarding of essential commodities by unscrupulous traders create temporary shortage in the markets and pushes prices of those commodities. 

Domestic Factors

Taxation and fiscal policies of Central, State and Local Governments have effect on prices of goods and services. Increase in excise duty, sale tax and local tax like octroi push the selling prices of goods. Developing country like India has lesser developed financial market which creates a weak bonding between interest rates and aggregate money demand. Scarcity of money supply pushes interest rates and the final price of products. Increase in prices of certain products, like petroleum, have cascading effect on the prices of many other products and services as transportation costs go up. Governments usually have deficit budgets and resort to print and issue new money in circulation to balance the budget. When the supply of money in circulation increases, prices rise. 

External Factors

When India has to depend on imports of certain products, like crude oil and petroleum products, any change in prices of those products by the exporting country has a direct impact on prices on domestic market. India has to import large quantity of crude oil and petroleum products and when the prices of these goods rise in international market, Indian consumers have to pay a higher price. India’s international trading is done through US Dollar. If due to variation in Rupee-Dollar exchange rates Rupee becomes weaker, higher cost of imports push prices in domestic market.

Government of India keeps a close watch on the economy and takes corrective actions to keep inflation in control. Government sometimes reduces duties and taxes to keep the prices in control and also gives subsidies on several items to hold the price line. In spite of this, one thing is certain that we have to live with inflation, year after year.  

Items of consumption included in CPI 

Consumer Price Index shows increase of prices over a period for certain items of consumption of goods and services. Following table shows items considered for compilation of CPI with percentage of each group of consumption with total expenses.

The above table indicates a broad pattern of expenditure that an average Indian family incurs on living, however, actual pattern of spending will be different by different families. CPI considers only certain items of consumption but there would be lot more items on which the family is incurring expenditure. Families also spend on consumer durables and also on social functions from their income which is not considered in CPI. Therefore, for preparing a financial plan, one will have to examine the spending habits of the family. CPI is just an indicator showing increase in basic cost of living.

Senior Citizens who live mainly on interest on the funds created by them over life time suffer the most by inflation. They have a fixed income while the cost of living increases month after month and gap between income and expenditure reduces month by month. Even if some persons are comfortable with their finances today, time may come when their expenditure will exceed their income and it would make it difficult for them to remain within their means. It is now the proper time for them to budget Receipts and Payments profile, or Funds Flow, for a longer period of, say, five to ten years and plan a strategy to overcome deficits in future years.

Effect of inflation on expenditure & saving in next 10 years

Considering the history of inflation in the last decade, we will assume that inflation in the next decade will at a compounding rate of 10% per annum. Following Table shows the amount of money required by a senior citizen with fixed income to continue maintain his present standard of living in next ten years. With growing age, expenditure profile will also change. A younger senior citizen may spend more on travel, entertainment and socialising than on health. In later years, his expenditure will be more on health than travel etc. The Table also shows surplus or deficit at the end of each year and cumulative surplus or deficit that he may have in next 10 years. In this example, a senior citizen has a gross fixed income of Rs. 5 lakh (ignoring income tax liability) per annum which is presumed to remain the same in next ten years and his expenditure in the year 2011 at Rs. 30,000 per month or Rs. 3,60,000 for the year which will increase year after year due to inflation at a compounding rate of 10% per year.

The table is a mathematical indication of how the financial position of the person will change in the next decade due to inflation. The table will alert him about a possibility of not being able to manage his expenses within his income in one of the years in future. The Table shows that expenses will marginally be more than income from the year 2015, however, as he has carry forward savings of earlier years, he will have overall surplus till the year 2017. From the year 2018, he will have deficits which will go to up to Rs.11.71 lakh by year 2021 unless he takes steps to turnaround his finances. He will not like such a thing to happen to him and he will think of finding answers to following questions.

Is it possible for him to raise income to match his expenditure when his financials show negative balance in the year 2015 and cumulative deficit in the year 2018 onwards?

Is it possible for him to reduce his expenditure right from the year 2012 so that he will be able to prolong the period of cumulative surplus and how long he can extend the period of cumulative surplus beyond the year 2018?

Is it possible for him to do the both, reduce his expenditure and raise his income so that he would be able to remain in cumulative surplus position forever?

How should he work on a plan right away to overcome the unsavoury situation which may arise in future?

There is one answer to all his queries, make a Budget for the next five to ten years.

The author has worked in the field of financial management over 50 years.