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Critical Topics and Their Significance for the UPSC CSE Examination on November 29, 2024

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How inflation affects cost of living?

For Preliminary Examination:  Consumer Price Index (CPI), Wholesale Price Index (WPI)

For Mains Examination: GS III - Economy

Context:

Driven by a 10.87 per cent spike in food prices, India’s retail inflation surged to a 14-month high of 6.21 per cent in October this year. While unseasonal rains and extended monsoons in certain parts of the country contributed to the surge in vegetable prices, rising global food and fuel prices due to geopolitical tensions also contributed to domestic inflation.

Read about:

Inflation

Consumer Price Index (CPI)

Wholesale Price Index (WPI)

Key takeaways:

What is Inflation?

Inflation is the rate at which the overall price level of goods and services rises over time, leading to a reduction in the purchasing power of money or real income. Simply put, as inflation increases, each unit of currency buys fewer goods and services than before.

Rising inflation has a significant impact on households, particularly those with fixed or lower incomes. As the prices of goods and services increase, the same nominal income can buy fewer items, thus raising the cost of living.

Understanding Nominal and Real Income

Nominal income refers to the total monetary earnings of an individual, household, or entity over a given period. For example, if someone earns ₹50,000 per month, this is their nominal income. However, as inflation rises, the real value of this amount diminishes.
Real income, on the other hand, represents the actual purchasing power of nominal income after accounting for inflation. It can be calculated using the formula:
Real Income = Nominal Income ÷ Price of Goods

Real Interest Rates and Inflation

Inflation also affects real interest rates, which are derived by subtracting the inflation rate from the nominal interest rate. For example, if the nominal interest rate is 10% and inflation is 8%, the real interest rate would be 2%.
Real Interest Rate = Nominal Interest Rate − Inflation Rate
When inflation rises, real interest rates decrease, potentially discouraging savings, as the real value of money grows at a slower pace.

Measuring Inflation

Several methods are used to measure inflation, each focusing on different aspects of price changes:

Consumer Price Index (CPI)

CPI measures changes in the general price level of goods and services purchased by households, including both domestically produced and imported items. Published monthly by the government, CPI reflects the inflation experienced by consumers. The formula for calculating inflation is:
Inflation Rate = ((CPI x+1 − CPI x ) / CPI x) × 100
Here, CPI x refers to the base year’s CPI value. Annual inflation rates are determined by comparing the current month’s CPI with that of the same month in the previous year. In India, the Ministry of Statistics and Programme Implementation (MoSPI) calculates and publishes CPI data at both national and state levels.

Wholesale Price Index (WPI)

While CPI reflects retail price changes, WPI measures wholesale market price changes for goods. It tracks the inflation rate across 697 bulk commodities but excludes the cost of services like haircuts or banking transactions, which are included in CPI.

For example, the WPI inflation rate for October 2024 in India was 2.36%, while the CPI inflation rate for the same period was 6.21%, highlighting differences in their scope and calculation.

GDP Deflator

The GDP deflator measures inflation by tracking changes in the prices of all domestically produced goods and services. It is calculated using the formula:
GDP Deflator = (Nominal GDP ÷ Real GDP) × 100
Unlike CPI, the GDP deflator includes all goods and services produced domestically but excludes imports, making it a comprehensive measure of inflation.

Producer Price Index (PPI)

PPI captures the average price changes received by producers for their goods and services. Unlike CPI, it focuses on prices from the producer’s perspective, excluding taxes, transport costs, and trade margins.

Wage Inflation

Wage inflation measures the rate at which wages increase over time, reflecting changes in labor market dynamics. Labor unions often negotiate wage hikes based on expected inflation to ensure a positive real wage increase. For instance, if inflation is projected at 2%, unions may push for a wage hike exceeding 2% to maintain workers' purchasing power

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