Measurement of Inflation: Price Index and Inflation Rate

Inflation is measured using a price index — a number that expresses the general price level in a given period relative to a chosen base year, whose index value is fixed at 100 by convention. If the index rises to, say, 120 the following year, it means the general price level has risen by 20% relative to the base year.

Two widely used price indices are studied in this context:

• Wholesale Price Index (WPI) — tracks prices at the wholesale/bulk-transaction level (the price a producer or wholesaler charges), and was historically India's main headline inflation measure.
• Consumer Price Index (CPI) — tracks the retail prices actually paid by final consumers for a representative basket of goods and services, and is now the index the RBI targets under its inflation-targeting monetary policy framework, since it reflects the cost of living a household actually experiences more directly than WPI does.

The inflation-rate formula. Once a price index is available for two periods, the inflation rate between them is:

For illustration, suppose a country's CPI stood at 200 in one year and rose to 220 the next year. The inflation rate for that year is $\dfrac{220-200}{200} \times 100 = 10\%$ — prices rose, on average, 10% over the year. This same formula, applied to CPI, is exactly what a Gujarat Board Std 12 Economics numerical on this chapter is testing, whatever the specific figures given.

Real income from a price index. The same index also lets us convert a money (nominal) income into a real income — what that income can actually buy relative to the base year: …