Tracking the Cost Living

Session 4
 About prices

General public averse to increase in prices of goods

Historically prices witness upward trend in general

People gossip about cheaper prices in the past

Prof. Amaresh Samantaraya 2

 CPI – Combined (2012=100)
160.0
155.3
150.0
146.3
140.0 139.6
135.0
130.0 130.3
124.7
120.0 118.9
110.0 112.2
100.0 102.5
90.0 93.3

Prof. Amaresh Samantaraya 3

 100.0
120.0
140.0

20.0
40.0
60.0
80.0

0.0
1970-71
1971-72
1972-73
1973-74
1974-75
1975-76

Prof. Amaresh Samantaraya

1976-77
1977-78
1978-79
1979-80
1980-81
1981-82
1982-83
1983-84
1984-85
1985-86
1986-87
1987-88
1988-89
1989-90
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
Wholesale Price Index

2008-09
2009-10
2010-11
2011-12
2012-13
2013-14
2014-15
2015-16
2016-17
2017-18
2018-19
2019-20
2020-21
4
 An Outline

Measuring price Purchasing

Inflation
level - CPI power parity

Prof. Amaresh Samantaraya 5

 Prices
Real • Labour theory of value
• Sum of labour units used to produce
prices • Labour embodied in capital goods, too

Nominal • Price in terms of currency units

• For example, price of a laptop is Rs.1.2 lakh
prices • Increase in money supply affects nominal prices

Prof. Amaresh Samantaraya 6

 Cost of Living
Amount of spending to purchase a basket of goods & services

As prices of goods & services rise, cost of living increase

As cost of living rises, a given income can buy fewer goods

Cost of living varies across places at same point of time

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 Measuring General Prices
CPI

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 Why to Construct an Index of Prices
Prices of different G&S rise differently, even some prices fall while that of other rise

Challenging to ascertain what happens to overall prices in the above situation

Construction of price indices help in gaining a perspective on movement of general

prices

Aim is to use a single number that summarizes changes in the general prices

Prof. Amaresh Samantaraya 9

 Market Basket
Consists of a bunch of goods and services that a typical household
regularly consumes

Set of goods and services kept fixed so that one can trace change
in cost of living

Quantities of respective goods and services also kept constant

Prof. Amaresh Samantaraya 10
 Change in Prices of Basket of Goods &
Services
Items 2020 2021 % Change
Rice 50 60 20.0
Dal 80 100 25.0
Apple 120 110 -8.3
Potato 52 58 11.5
Milk 22 24 9.1
House Rent 20000 22000 10.0
Petrol 90 100 11.1
School Fees 100000 75000 -25.0
6.7
Prof. Amaresh Samantaraya 11
 Question

• Can we say that the cost of living for a typical

household has increased by 6.7%, in general?

Prof. Amaresh Samantaraya 12

 Intuition
• Increase in price of some items are more important than price of
some other goods
• In our example, change in house rent will have much greater
impact on the household overall spending than the price of apple.
• Total expenditure on the basket depends both on unit price of the
item as also the quantity of consumption on each item in a year.

Prof. Amaresh Samantaraya 13

 Change in Cost of Living
Items Quantity (in a year) 2020 2021 % Change
Rice 240 kgs 12000 14400
Dal 96 kgs 7680 9600
Percentage
Apple 60 kgs 7200 6600 Change in Cost
Potato 84 kgs 4368 4872 of Living
Milk 1440 packets 31680 34560
House Rent 12 months 240000 264000 1.9
Petrol 180 litres 16200 18000
School Fees 1 kid 100000 75000
421148 429053
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 Consumer Price Index (CPI)

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 Price Indices
• Using the market basket approach, price indices are constructed to track const of
living
• Popular indices are
• Consumer Price Index (CPI)
• Producer Price Index (PPI)
• In India, Wholesale Price Index (WPI) was the most important price index until recently
• CPIt = (Cost of Market Basket in Year ‘t’/Cost of Market Basket in the base
year)*100 – It is widely used for policy purposes
• CPIt indicates the cost of maintaining the same standard of living as in the base
year in the year ‘t’
Prof. Amaresh Samantaraya 16
Prof. Amaresh Samantaraya 17
 India – CPI (2012=100)
Compiled by the CSO, Min. of Statistics & Programme Implementation

Details: Consumer Price Index: Changes in the Revised Series,

CSO (Prices and Cost of Living Unit) 2015

Weights are based on 68th Round of NSS (Weight Ref Year: 2011-12)

Prof. Amaresh Samantaraya 18

Prof. Amaresh Samantaraya 19
Prof. Amaresh Samantaraya 20
 Challenges in Construction of CPI
• Selection of goods and services to be included in the market basket, such that CPI
reflects cost of living of the widest group of people
• Items of consumption basket vary from one household to another
• Summary basket drawn from household surveys
• Substitution and Innovation
• As price and income change, goods are substituted for others
• In the process of innovations new goods and services emerge, and some others become obsolete
• Same items of goods come with new features and quality improvement
• Creating a basket that balances above requirements – tricky judgement call
Prof. Amaresh Samantaraya 21
 Changing Weights in WPI
Base Year Primary Fuel & Power Manufacturing

1970-71 41.7 8.5 49.9

1981-82 32.3 10.7 57.0

1993-94 22.0 14.2 63.8

2004-05 20.1 14.9 65.0

2011-12 22.6 13.2 64.2

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 Measuring Inflation

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How relevant is ‘inflation’ for an economy?
• Inflation is surge in general prices. Measured as the percentage change in CPI
in the current year over the previous year
• If CPI2020=120, and CPI2021=130, then Inflation in 2021=[(130-120)/120]*100=8.3%
• High inflation in inimical to economic growth
• Discourages domestic saving
• Makes imports cheaper and exports costly – harmful for foreign trade
• Distorts price signals, and leads to sub-optimal resource allocations
• Public policy to arrest high inflation causes output loss
Prof. Amaresh Samantaraya 24
 Use of CPI

• Headline inflation
For measuring inflation • Core inflation

Deflating Nominal • Nominal GDP to Real GDP

Variable • Compares Wealth over time

Indexing by adjusting for • DA calculation for employees

Inflation • Social welfare packages

Prof. Amaresh Samantaraya 25

 -10.0
-5.0
10.0
15.0
20.0
25.0
30.0

0.0
5.0
1971-72
1972-73
1973-74
1974-75
1975-76

Prof. Amaresh Samantaraya

1976-77
1977-78
1978-79
1979-80
1980-81
1981-82
1982-83
1983-84
1984-85
1985-86
1986-87
1987-88
1988-89
1989-90
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
WPI Inflation

2003-04
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12
2012-13
2013-14
2014-15
2015-16
2016-17
2017-18
2018-19
2019-20
2020-21
26
 Nominal and Real GDP
25000000
20000000
15000000
10000000
5000000
0

GDP-Current GDP-Constant
Prof. Amaresh Samantaraya 27
 DA Calculation
• Under 7th Pay Commission (Beginning from January 2016), DA for Central
Government employees:
• DA(%) = [(Average of CPI-IW for past 12 months – CPI-IW in 2015)/
(CPI-IW 2015)]*100, where CPI-IW in 2015=261.4
• New DA Calculation since September 2020
• CPI-IW (Base year: 2016) replaced CPI-IW (Base year: 2001) – published by Labour
Bureau, Ministry of Labour and Employment, GoI

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 Purchasing power parity
Accounting for price differences across places

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 Principle of One Price
• Any particular good should cost same across countries, if expressed in the same
currency
• For example, a Toyota Land Cruiser should cost same in terms of say, US dollar
• It’s Indian price is Rs.1.47 crore. It should cost $ 1.99 lakh in the US, Japan, and elsewhere
(using the exchange rate of 1 $ = 73.88 Rupees)
• House rent for a standard 2 BHK flat should be same in London and New Delhi,
in terms of US dollar

Prof. Amaresh Samantaraya 30

 Issue

• However, if we need to compare incomes or costs of

living across the nations, it is imperative to adjust for
nominal prices in different places, expressed in a
common currency
• Purchasing power indices – become useful in the above
context
Prof. Amaresh Samantaraya 31
 Purchasing Power Indices
• Construct a market basket of goods & services that we wish to
1 compare across the countries

• Using price of goods and services in the basket in each country,

2 we can calculate the Cost of Purchasing across the countries

• We can compare the cost of the basket in each country relative

3 to a common base, and build the PP indices

Prof. Amaresh Samantaraya 32

 Big Mac Index – The Economist
• Big Mac – A standard product – requires a variety of inputs such as meat, bread,
lettuce, labour, real estate, advertising, etc.
• McDonald’s international production and sourcing policies – locally procured
• In 2018, the price of Big Mac was $5.51 in the US and 50 pesos in Mexico
• So, PPP Exchange Rate = 50 pesos/$5.51 = 9.07 pesos per dollar
• In that year, market exchange rate (official): 20.1 pesos per dollar
• Big Mac Index for Mexico (Undervaluation of pesos vis-à-vis dollar) =
[(9.07-20.1)/(20.1)]*100 = -54%

Prof. Amaresh Samantaraya 33

 Undervaluation/Overvaluation of Different
Currencies against US dollar (July 2021)
Sl. Country (-)/(+) Sl. Country (-)/(+)
No. against $ No. against $
1 India - 54 9 6 Switzerland 24.7
2 China - 38.8 7 Sweden 9.6
3 Brazil - 22.8 8 Japan - 37.2
4 South Africa - 59.6 9 UK - 15.9
5 Singapore - 24.7 10 Euro Area - 11.1
Prof. Amaresh Samantaraya 34
 Interpretation
• A negative sign suggests – price levels in the concerned country (India) are relatively
lower
• Real purchasing power of the domestic currency (Rupee) is higher
• If US dollar is exchanged for Rupee, they will buy more goods and services in India
than in the US
• On the contrary, a positive sign suggests – the currency is overvalued than that
implied from PPP

Prof. Amaresh Samantaraya 35

 International Comparison Program (ICP) –
World Bank
• Produce Purchasing Power Parities (PPPs) and comparable Price Level
Indices (PLIs) for participating countries – 176
• To convert GDP, Per capita GDP, etc, to a common currency using PPPs
• Based on a common basket of goods and services in each participating
country – reference year 2017

Prof. Amaresh Samantaraya 36

 PPP-adjusted GDP
• PPP Adjusted GDP =
• Nominal dollarscountryA * (1ൗ(1−𝑃𝑟𝑖𝑐𝑒−𝑙𝑒𝑣𝑒𝑙 𝐴𝑑𝑗𝑢𝑠𝑡𝑚𝑒𝑛𝑡𝑐𝑜𝑢𝑛𝑡𝑟𝑦 ))
𝐴

• Example: Nominal GDP for Mexico=$8,903; Price-level adjustment for

Mexico=0.514, then
• PPP –adjusted GDP for Mexico = ($ 8903)*(1ൗ(1−0.514))=$ 8903*2.0576
• = $ 18318.93
• It implies that an average Mexican lives about as well as someone who earns $ 18,319
in the US
Prof. Amaresh Samantaraya 37
 India
8000.0
7000.0
6000.0
5000.0
4000.0
3000.0
2000.0
1000.0
0.0
2003

2010

2017
2001
2002

2004
2005
2006
2007
2008
2009

2011
2012
2013
2014
2015
2016

2018
2019
2020
PC-GDP PC-GDP PPP
Prof. Amaresh Samantaraya 38
 China
18000
16000
14000
12000
10000
8000
6000
4000
2000
0

2020
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
PC-GDP PC-GDP PPP
Prof. Amaresh Samantaraya 39
 Question

• Does the principle of one price hold in reality?

Prof. Amaresh Samantaraya 40

 Why the Principle of One Price does not hold?
Prices of Factors of Production vary – Production Cost

Transaction cost involved

Certain goods are non-tradeable – House

Trades restrictions
Prof. Amaresh Samantaraya 41