Different measures of inflation in an economy
The main objective of this paper is to identify the different measures of inflation in an economy. Within different sectors of the economy, there are different measures of inflation that can be deployed. Generally, inflation can be defined as the overall increase in product prices. In this box, the consumer price index will be used to make an analysis of the different measures of inflation and thus identify the movement between producer price index, gross domestic product (deflator), and the trade-weighted U.S. dollar index. The consumer price index (CPI) is an economic variable that measures the weighted average price of consumer goods and services over a given period. For example, the consumer price index interprets measurement of the price examination such as housing and food. In the computation of the CPI, the change in prices for a specific period, and the predetermined basket of consumer goods is taken an average. The computed CPI can also be used to measure the price change and associate it with the household cost of living. As a result of the CPI finding in the calculation, it is mostly used as the key economic indicator in the identification of inflation and deflation periods.
The first measure of inflation is the producer price index. The CPI will be compared with the producer price index on all commodities that will be referred to the PPI. The producer price index is calculated through the average of the price changes on the producer goods and services. Within the manufacturing industries, wholesale market, and commodities market, the producer price index is used to measure and show the trends. The producer price index in the U.S economy accounts for all the physical goods-producing industries. The economic difference between the consumer price index and the producer price index is the composition terms of the goods and services covered, as well as the types of prices collected with the extent of the sector coverage. The producer price index is an important parameter in terms of prices as it can serve as a leading indicator at the consumer level for the ultimate price change and inflation if the PPI trend is high. To gain a better understanding of the CPI and PPI comparison, figure one below shows the annualized growth.
FIGURE 1: Annualized Growth Rate: PPI & CPI (monthly): Jan 1960-July 2018
Form figure 1 above, the trend for CPI from 1960 through 2018 has a steady increase and decrease relative to the PPI. This means that as the PPI increases the CPI also increases but it might be as high as the increase in the CPI. As the PPI fluctuates over time, the CPI also changes as the product prices are determined by the PPI. This measurement indicates that the selling price of goods and services is the comparison of the weighted average prices of products in general. The fundamental reason why the consumer price index and producer price index are close is because of the simple fact that there is a direct relationship between the two as they both involve product prices. In measuring inflation, the two economic indicators are used as they are the main price indexes, and their relationship primarily based on consumer prices. From the figure above, both the PPI and the CPI show a similar rate for inflation in the long-run. This trend might change in the short run as the PPI increase at a higher rate as compared to the CPI. This trend is evident in the early period of figure 1 above.
The second measure of inflation is the Gross Domestic Product Price Deflator. This inflation measure is very different from the GDP, as the GDP price deflator is an economic parameter which takes into account the aspect of inflation through converting the total output measured at current product prices into constant-dollar GDP. This deflator plays an important role in determining the product price levels in an economy as it shows how much the change in the base year’s GDP is dependent on the price levels. A typical GDP is measured as the overall monetary value of the finished products in an economy for a specific period. On the other hand, the GDP price deflator gives more details in terms of measurement parameters for the extent of inflation in an economy. The price deflator accounts for all prices straight from goods and services for businesses, consumer purchased goods and services, and government purchases. The GDP price deflator is a vital parameter in measuring inflation as the real GDP differs from the nominal GDP. The main difference between nominal GDP and real GDP is that under nominal GDP inflation is factored in, unlike real GDP where it is not included. Figure 2 below shows the relationship between GDP deflator and CPI.
FIGURE 2: GDP Implicit Price Deflator & CPI (quarterly): Jan 1960-April 2018
Form the figure above, it is evident that the relationship between CPI and the GDP deflator is overlapping at some point. The reason the two economic indicators overlap is that they represent two sets of different prices in the economy. As pointed out earlier, the GDP deflator is an index used to measure the price level of all goods and services within an economy while the CPI measures the price levels of all goods purchased by the consumers in an economy. From figure 2 above, there are more fluctuations in the CPI as compared to the GDP deflator. The reason why there are more fluctuations in the CPI is that the prices are influenced by consumers. Through the years in figure 2 above, both CPI and GDP deflator shows a close trend of being close but overlapping. However, CPI is more volatile than GDP deflator for the simple reason that GDP accounts for overall prices in the entire economy. From figure 2 above, the GDP deflator is more stable and constant a time near the great recession, while CPI reflects the biggest drop.
The last measure of inflation is the Trade Weighted U.S. dollar index. A trade-weighted dollar is the general measure of the foreign exchange value when a single unit of the U.S dollar is compared to other foreign currencies. The trade-weighted dollar gives high value to foreign currencies that are widely used in international trade. These foreign currencies are compared to the U.S dollar to give either high value or low-value weight in the trade market. Because different foreign currencies have different weights, the same follows on the effect on the trade-weighted dollar. To gain a better understanding of the trade-weighted U.S. dollar index effect on inflation, one must interpret correctly the impact of CPI on the currencies. For example, during the economic times when the inflation is low, the federal reserve takes up monetary policies to control the same through cutting the interest rates thus encouraging economic activities. On the contrary, when the inflation rises, the federal reserve increases the interest rates intending to stabilize the prices. Under foreign exchange, the consumer price index is closely and continuously monitored in an economy because it can result in strengthening or weakening the currency. Figure 3 below shows the relationship between CPI and the trade-weighted U.S. dollar index.
FIGURE 3: Trade Weighted U.S. Dollar Index- Broad & CPI: Jan 1973-July 2018
From figure 3 above, the CPI has shown a constant trend since 1973 through 2018, while the trade-weighted U.S. dollar index has a fluctuating trend. This implies that a slight change in the CPI can have a huge effect on the trade-weighted U.S. dollar index. For instance, in 2009, the CPI dropped and the trade-weighted U.S. dollar index spiked high as a result of the change in CPI.
In conclusion, the relationship between the trade-weighted U.S. dollar index and CPI is inverse as opposed to the relationship between GDP inflator and PPI. The trade-weighted U.S. dollar index appears to be more volatile as compared to other measures of inflation. This analysis shows how different measures of inflation can have different effects on the economic sectors. The trade-weighted U.S. dollar index, GDP inflator, and PPI show the relationship and trend movement in comparison to the CPI within an economy in the measurement of inflation.