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The Head and Tail of Wholesale PriceIndex vs Consumer Price Index

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Changes and movement in prices influence buying and selling decisions, and thus the economicscenario. Hence the government, businesses, producers and consumers keep a constant check onprices. However, given the large number of items that are sold and purchased every day, it isdifficult to keep track of all of them.

That is where price indices come in. They give a sense of the overall direction and trend in prices.These indices are available for different sectors and for different groups of people.

There are indices based on prices in different markets or at different points of sales. Of the manyindices, two are of critical importance. The first is the Wholesale Price Index (WPI), which isbased on the price prevailing in the wholesale markets or the price at which bulk transactions aremade. The other is the Consumer Price Index (CPI), which is based on the final prices of goods atthe retail level. Both these indices are the weighted averages of prices of a specified set of goodsand services. The WPI is compiled and published by Office of the Economic Advisor on a weeklybasis while the CPI is compiled and published by the Labour Bureau on a monthly basis in India.The CPI is published for rural, agricultural and industrial workers.

The use of price indicesThese indices are used for various purposes, including for forecasting in businesses, used byorganizations and institutions for their analysis, and by the RBI and the government of India toframe monetary and fiscal policy, etc. The WPI is used to measure inflation in India because ofthe non-availability of appropriate CPI. It is used to deflate national income to calculate realoutput in the economy. Also exchange rates are often adjusted on the basis of WPI. For example,(hypothetical since India has flexible exchange rate) suppose the WPI index in India rises bycertain points (inflation). In order to maintain the purchasing power of the rupee vis-a-vis othercurrencies, the rupee is depreciated. This would keep the price of Indian goods same in terms offoreign currency, in spite of the inflation in India.
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The cost of projects, price of supply of goods based on future contracts are often subject tochange with these indices. As these indices change, cost and supply prices are changedaccordingly. For example, an increase in the WPI may lead to increase in contract price of goods.This role of indices will increase substantially in the future as economy matures and as newmarkets develop for contractual trading. Also, often the wages and salaries are indexed to

inflation.

Problems with WPIHowever, although the WPI is used in India for various purposes, there are flaws in it. For manycommodities like cars, wholesale markets may not exist. Also with increased competition, pricesbased on costs, and the reduced role of government in trading of goods and services, it is difficultto obtain prices and price data from private producers. The WPI doesnt take the price of servicesinto consideration, which now accounts for 60 percent of the GDP. Also, it is too general andcannot be used for specific purposes. For example, if an individual wants to know the trends inoffice stationery products, then WPI may not capture the correct or complete picture. Somecommodities may have higher weights during a particular period and may not be consumedduring other. For example, woolen textiles are part of the consumption basket only for four

months in a city like Delhi. So a constant revision of weights is required in this regard. Anotherproblem is that the share of expenditure of commodities may change overtime. For instance, theexpenditure on computers, which were seldomly available before 1990s but now have asignificant share in the expenditure of an urban Indian. So the weights of these indices need to bechanged over time.

WPI and CPI in IndiaInflation in India, measured by WPI, reached 12.9% on August 2, 2008 but fell sharply to 0.3% inMarch 2009 and negative in June 2009. The reason for such high volatility was the primarily


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fluctuation in international commodity prices. However, unlike WPI-based inflation, CPI-basedinflation remained high. It did increase with the WPI but did not come down proportionatelywhen wholesale prices fell. This indicates that intermediaries between consumers and wholesalersor retailers or both have not passed on the low-cost benefits to the customers and so have enjoyedincreasing margins.

The graph clearly shows that for most of the time, the rate of growth of the CPI is more than therate of growth of the WPI, except when there are steep rises in the WPI during 2006 and 2008.This may be due to the inability of retailers or intermediaries to pass on the increasing cost to theconsumers so quickly. This may also point out towards the existence of competition in themarkets.

Businesses Strategies and Price IndicesThese indices help businesses and can prove to be an effective analytical tool for them. Thesetrends affect the economic policies and monetary policies of the government and RBIrespectively. High inflation rates are often followed by tight monetary policies. In India, the WPIis related to interest rates as inflation is measured on the basis of the WPI. High inflation ratesmay point towards increasing interest rates. However, other factors also come into play while

determining interest rates but inflation is a major one.

These indices play a role in affecting sentiments. Low inflation rates may lead to a sentimentwhere investments financed through loans are deferred because of the expectation of lowerinterest rates in the future. Certain expectations are formed based on the effects on overalleconomy due to movements in these indices. For example, high inflation rates create a gloomysentiment about the economy and people generally tend to defer investments in that case. Also,consumers tend to defer their heavy expenditures during inflation due to expectancy of fall inprices. For instance, housing expenditure. However, other day-to-day expenditures like grocery,energy, etc are generally not affected due to changes in these indices.

It should be noted that falling inflation never means that prices are falling. Only negative inflationor a fall in these indices imply that prices are falling. Falling inflation (positive) or decreasing rateof increase in these indices only imply that prices are rising at a slower pace. So falling inflationfor consumer does not mean that he/she has to pay a lower price in the future.

These indices also give insights whether holding an asset is justifiable or not. For example, if anasset price rise is less than the inflation in the economy, then this may point out towards erosionof purchasing power of the asset holder. In other words this means that an asset holder may not beable to purchase the same quantity of goods in the next period if price rise in asset isproportionately less than the rise in these indices by selling that asset. So investment in assetsmust be made keeping this in mind. An absolute increase in the price of the asset does notdefinitely mean that the asset holder has gained in real terms.

Also movements or changes in these indices affect the futures market. High inflation rate and

increasing trend may point towards higher price in future and hence higher prices of futurescontracts. Large movements or fluctuations in these indices often open up the opportunity forarbitrage, which is making profit due to price differences in two markets (here different marketsrefer to future and spot market).

If trends are analyzed (in graph also) then it would be clear that large margins or the gap betweenthe rate of increase of WPI and CPI could not be maintained for a long period of time because ofthe existence of competition in most of the markets. Trends indicate that a fall in WPI inflation isoften followed by a fall in CPI inflation. So if the current situation is assessed, then it can be the


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an economy strongly outweighs the aggregate supply, prices increase. Economists will often saythat demand-pull inflation is a result of too many dollars chasing too few goods.

Investopedia explainsDemand-Pull InflationThis type of inflation is a result of strong consumer demand. When many individuals are tryingto purchase the same good, the price will inevitably increase. When this happens across theentire economy for all goods, it is known as demand-pull inflation.

Cost-Push Inflation Versus Demand-PullInflationDo you remember how much less you paid for things even two years ago? This increase in thegeneral price level of goods and services in an economy is inflation, measured by the ConsumerPrice Index and the Producer Price Index. (seeAll About Inflationand What is inflation?) Butthere are different types of inflation, depending on its cause. Here we examine cost-pushinflation and demand-pull inflation.

Factors of InflationInflation is defined as the rate (%) at which the general price level of goods and services isrising, causingpurchasing powerto fall. This is different from a rise and fall in the price of a

particular good or service. Individual prices rise and fall all the time in a market economy,reflecting consumer choices or preferences and changing costs. So if the cost of one item, say aparticular model car, increases because demand for it is high, this is not considered inflation.Inflation occurs when mostprices are rising by some degree across the whole economy. This iscaused by four possible factors, each of which is related to basic economic principles of changesin supply and demand:

1. Increase in the money supply.

2. Decrease in the demand for money.

3. Decrease in the aggregate supply of goods and services.

4. Increase in the aggregate demand for goods and services.

In this look at what inflation is and how it works, we will ignore the effects of money supply oninflation and concentrate specifically on the effects of aggregate supply and demand: cost-pushand demand-pull inflation.

Cost-Push InflationAggregate supply is the total volume of goods and services produced by an economy at a givenprice level. When there is a decrease in the aggregate supply of goods and services stemmingfrom an increase in the cost of production, we have cost-push inflation. Cost-push inflation
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basically means that prices have been pushed up by increases in costs of any of the four factorsof production (labor, capital, land or entrepreneurship) when companies are already running atfull production capacity. With higher production costs and productivity maximized, companiescannot maintain profit margins by producing the same amounts of goods and services. As aresult, the increased costs are passed on to consumers, causing a rise in the general price level(inflation).

Production CostsTo understand better their effect on inflation, lets take a look into how and why production costscan change. A company may need to increases wages if laborers demand higher salaries (due toincreasing prices and thus cost of living) or if labor becomes more specialized. If the cost oflabor, a factor of production, increases, the company has to allocate more resources to pay for thecreation of its goods or services. To continue to maintain (or increase)profit margins, thecompany passes the increased costs of production on to the consumer, making retail priceshigher. Along with increasing sales, increasing prices is a way for companies to constantlyincrease theirbottom lines and essentially grow. Another factor that can cause increases inproduction costs is a rise in the price of raw materials. This could occur because of scarcity of

raw materials, an increase in the cost of labor and/or an increase in the cost of importing rawmaterials and labor (if the they are overseas), which is caused by a depreciation in their homecurrency. The government may also increase taxes to cover higher fuel and energy costs, forcingcompanies to allocate more resources to paying taxes.

Putting It TogetherTo visualize how cost-push inflation works, we can use a simple price-quantity graph showingwhat happens to shifts in aggregate supply. The graph below shows the level of output that canbe achieved at each price level. As production costs increase, aggregate supply decreases fromAS1 to AS2 (given production is at full capacity), causing an increase in the price level from P1to P2. The rationale behind this increase is that, for companies to maintain (or increase) profitmargins, they will need to raise the retail price paid by consumers, thereby causing inflation.

Demand-Pull InflationDemand-pull inflation occurs when there is an increase in aggregate demand, categorized by thefour sections of the macroeconomy: households, businesses, governments and foreign buyers.
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When these four sectors concurrently want to purchase more output than the economy canproduce, they compete to purchase limited amounts of goods and services. Buyers in essencebid prices up, again, causing inflation. This excessive demand, also referred to as too muchmoney chasing too few goods, usually occurs in an expanding economy.

Factors Pulling Prices UpThe increase in aggregate demand that causes demand-pull inflation can be the result of variouseconomic dynamics. For example, an increase in government purchases can increase aggregatedemand, thus pulling up prices. Another factor can be the depreciation of local exchange rates,which raises the price of imports and, for foreigners, reduces the price of exports. As a result, thepurchasing of imports decreases while the buying of exports by foreigners increases, therebyraising the overall level of aggregate demand (we are assuming aggregate supply cannot keep upwith aggregate demand as a result of full employment in the economy). Rapid overseas growthcan also ignite an increase in demand as more exports are consumed by foreigners. Finally,if government reduces taxes, households are left with more disposable income in their pockets.This in turn leads to increased consumer spending, thus increasing aggregate demand andeventually causing demand-pull inflation. The results of reduced taxes can lead also to growing

consumer confidence in the local economy, which further increases aggregate demand.

Putting It TogetherDemand-pull inflation is a product of an increase in aggregate demand that is faster than thecorresponding increase in aggregate supply. When aggregate demand increases without a changein aggregate supply, the quantity supplied will increase (given production is notat fullcapacity). Looking again at the price-quantity graph, we can see the relationship betweenaggregate supply and demand. If aggregate demand increases from AD1 to AD2, in the short run,this will notchange (shift) aggregate supply, but cause a change in the quantity supplied asrepresented by a movement along the AS curve. The rationale behind this lack of shift inaggregate supply is that aggregate demand tends to react faster to changes in economicconditions than aggregate supply.

As companies increase production due to increased demand, the cost to produce each additionaloutput increases, as represented by the change from P1 to P2. The rationale behind this change isthat companies would need to pay workers more money (e.g. overtime) and/or invest inadditional equipment to keep up with demand, thereby increasing the cost of production. Just likecost-push inflation, demand-pull inflation can occur as companies, to maintain profit levels, passon the higher cost of production to consumers prices.


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ConclusionInflation is not simply a matter of rising prices. There are endemic and perhaps diverse reasons at

the root of inflation. Cost-push inflation is a result of decreased aggregate supply as well as

increased costs of production, itself a result of different factors. The increase in aggregate supply

causing demand-pull inflation can be the result of many factors, including increases in

government spending and depreciation of the local exchange rate. If an economy identifies what

type of inflation is occurring (cost-push or demand-pull), then the economy may be better able to

rectify (if necessary) rising prices and the loss of purchasing power.

Macroeconomic Analysis

When the price of a product you want to buy goes up, it affects you. But why does the price goup? Is the demand greater than the supply? Did the cost go up because of the raw materials thatmake the CD? Or, was it a war in an unknown country that affected the price? In order to answerthese questions, we need to turn to macroeconomics.What Is It?Macroeconomics is the study of the behavior of the economy as a whole. This is different from

microeconomics, which concentrates more on individuals and how they make economicdecisions. Needless to say, macroeconomy is very complicated and there are many factors thatinfluence it. These factors are analyzed with various economic indicators that tell us about theoverall health of the economy.

Macroeconomists try to forecast economic conditions to help consumers, firms and governmentsmake better decisions.
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Consumers want to know how easy it will be to find work, how much it will cost to buygoods and services in the market, or how much it may cost to borrow money.

Businesses use macroeconomic analysis to determine whether expanding production willbe welcomed by the market. Will consumers have enough money to buy the products, orwill the products sit on shelves and collect dust?

Governments turn to the macroeconomy when budgeting spending, creating taxes,deciding on interest rates and making policy decisions.

Macroeconomic analysis broadly focuses on three things: national output (measured by grossdomestic product (GDP)), unemployment and inflation. (For background reading, seeTheImportance Of Inflation And GDP.)

National Output: GDPOutput, the most important concept of macroeconomics, refers to the total amount of goods andservices a country produces, commonly known as the gross domestic product. The figure is like asnapshot of the economy at a certain point in time.

When referring to GDP, macroeconomists tend to use real GDP, which takes inflation intoaccount, as opposed to nominal GDP, which reflects only changes in prices. The nominal GDPfigure will be higher if inflation goes up from year to year, so it is not necessarily indicative ofhigher output levels, only of higher prices.

The one drawback of the GDP is that because the information has to be collected after aspecified time period has finished, a figure for the GDP today would have to be an estimate.GDP is nonetheless like a stepping stone into macroeconomic analysis. Once a series of figuresis collected over a period of time, they can be compared, and economists and investors can beginto decipher thebusiness cycles, which are made up of the alternating periods between economicrecessions (slumps) and expansions (booms) that have occurred over time.

From there we can begin to look at the reasons why the cycles took place, which could begovernment policy, consumer behavior or international phenomena, among other things. Ofcourse, these figures can be compared across economies as well. Hence, we can determine whichforeign countries are economically strong or weak.

Based on what they learn from the past, analysts can then begin to forecast the future state of theeconomy. It is important to remember that what determines human behavior and ultimately theeconomy can never be forecasted completely.

UnemploymentThe unemployment rate tells macroeconomists how many people from the available pool of

labor (the labor force) are unable to find work. (For more about employment, see Surveying TheEmployment Report.)

Macroeconomists have come to agree that when the economy has witnessed growth from periodto period, which is indicated in the GDP growth rate, unemployment levels tend to be low. Thisis because with rising (real) GDP levels, we know that output is higher, and, hence, morelaborers are needed to keep up with the greater levels of production.
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InflationThe third main factor that macroeconomists look at is the inflation rate, or the rate at whichprices rise. Inflation is primarily measured in two ways: through the Consumer Price Index (CPI)and the GDP deflator. The CPI gives the current price of a selected basket of goods and servicesthat is updated periodically. The GDP deflator is the ratio of nominal GDP to real GDP. (Formore on this, see The Consumer Price Index: A Friend To Investors and The Consumer PriceIndex Controversy.)

If nominal GDP is higher than real GDP, we can assume that the prices of goods and services hasbeen rising. Both the CPI and GDP deflator tend to move in the same direction and differ by lessthan 1%. (If you'd like to learn more about inflation, check outAll About Inflation.)

Demand and Disposable IncomeWhat ultimately determines output is demand. Demand comes from consumers (for investmentor savings - residential and business related), from the government (spending on goods andservices of federal employees) and from imports and exports.

Demand alone, however, will not determine how much is produced. What consumers demand isnot necessarily what they can afford to buy, so in order to determine demand, a consumer'sdisposable income must also be measured. This is the amount of money after taxes left forspending and/or investment.

In order to calculate disposable income, a worker's wages must be quantified as well. Salary is afunction of two main components: the minimum salary for which employees will work and theamount employers are willing to pay in order to keep the worker in employment. Given that thedemand and supply go hand in hand, the salary level will suffer in times of high unemployment,and it will prosper when unemployment levels are low.

Demand inherently will determine supply (production levels) and an equilibrium will be reached;however, in order to feed demand and supply, money is needed. The central bank (the FederalReserve in the U.S.) prints all money that is in circulation in the economy. The sum of allindividual demand determines how much money is needed in the economy. To determine this,economists look at the nominal GDP, which measures the aggregate level of transactions, todetermine a suitable level of money supply.

Greasing the Engine of the Economy - What the Government Can DoMonetary PolicyA simple example ofmonetary policy is the central bank's open-market operations. (For moredetail, see theFederal Reserve Tutorial.) When there is a need to increase cash in the economy,the central bank will buy government bonds (monetary expansion). These securities allow the

central bank to inject the economy with an immediate supply of cash. In turn, interest rates, thecost to borrow money, will be reduced because the demand for the bonds will increase their priceand push the interest rate down. In theory, more people and businesses will then buy and invest.Demand for goods and services will rise and, as a result, output will increase. In order to copewith increased levels of production, unemployment levels should fall and wages should rise.

On the other hand, when the central bank needs to absorb extra money in the economy, and pushinflation levels down, it will sell its T-bills. This will result in higher interest rates (less
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borrowing, less spending and investment) and less demand, which will ultimately push downprice level (inflation) but will also result in less real output.

Fiscal PolicyThe government can also increase taxes or lower government spending in order to conductafiscal contraction. What this will do is lower real output because less government spendingmeans less disposable income for consumers. And, because more of consumers' wages will go totaxes, demand as well as output will decrease.

A fiscal expansion by the government would mean that taxes are decreased or governmentspending is increased. Ether way, the result will be growth in real output because the governmentwill stir demand with increased spending. In the meantime, a consumer with more disposableincome will be willing to buy more.A government will tend to use a combination of both monetary and fiscal options when setting

policies that deal with the macroeconomy.

Conclusion

The performance of the economy is important to all of us. We analyze the macroeconomy by

primarily looking at national output, unemployment and inflation. Although it is consumers who

ultimately determine the direction of the economy, governments also influence it through fiscal

and monetary policy.
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