Beginners:Inflation

Highlights


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This article is part of Statistics 4 beginners, a section in Statistics Explained where statistical indicators and concepts are explained in a simple way to make the world of statistics a bit easier for pupils and students as well as for everyone else with an interest in statistics.

Watch the video explaining how the inflation rate is calculated

In a market economy where prices are determined by supply and demand, prices simply reflect what you have to pay for a product. These products can be goods such as a book or services such as a haircut.

The price of a good or service depends not only on their characteristics, but also where it is sold and in what condition. At a particular point in time, prices of even identical products vary between shops. For example, for a pair of jeans, prices differ according to the brand or model, and whether they are bought in a specific shop on a particular day or in a certain quantity (as a discount might be offered when buying several pairs).


Full article

Many different kinds of prices

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Example

Max goes to a shop to buy a smartphone. The price that Max pays in the shop is called a retail or consumer price. 'Retail' reflecting the fact that Max has bought the phone from a retail outlet such as a shop; 'consumer' reflecting the fact that Max has bought the phone for his own personal use, and not to use it in a business.


The shop owner, Sandra, receives the payment from Max: some of the money is used to order another phone to replace in her stock the phone she has sold, some of it (the value added tax (VAT)) has to be passed on to the state, while the rest is for Sandra to use for other payments and for savings.
Sandra buys her phones from Stefan: he is a wholesaler selling phones in the country where Sandra has her shop. The price that Stefan charges Sandra is called the wholesale price.


Stefan’s phones come from two sources: some of them are manufactured in the country where he has his wholesale business and some are imported from abroad.
If the phone is produced in the country where Stefan has his business, the price that he is charged is a producer price.
However, if the phone is being imported an import price is charged.
The local manufacturer of the phone not only sells goods locally within the domestic economy, but may also export phones abroad, for which they charge an export price.

As you can see from the example above, there are many different kinds of prices, meaning that the price of a product changes as it moves through the economy — the information presented below focuses only on consumer prices.

What is inflation?

Consumer prices are of great interest simply because we are all confronted with them every day. Prices can change over time and vary across countries or regions. Even the same product that is purchased under the same conditions and at the same place may have different prices, just because it is bought at a different period of time — this is due to inflation and deflation.

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Inflation is a general increase in prices , while deflation is a decrease in prices.
When there is inflation in an economy, the value of money decreases because people would need to spend more money to buy the same products than previously. Deflation is the opposite of inflation: the value of money increases and people would need to spend less money than previously for the same products.
As inflation is generally more common, the change in prices is often simply referred to as inflation.

How is inflation measured?

Inflation is measured through consumer price indices, which show the development over time of prices of goods and services paid by people (consumers). In other words, a price index compares the prices of a set of products at different points in time. A price index shows how much must be paid for a product at one point in time relative to what would have been paid for the same product at another point in time.

Within the European Union (EU) there are common standards for producing such indices to ensure the consistency at European level. These indices are called the Harmonised Index of Consumer Prices (HICP). These common standards are there to ensure that comparable inflation rates are produced across the EU Member States.

What is needed to calculate a consumer price index?

To calculate such an index we need:

  • a classification of products (goods and services);
  • a set of weights;
  • a selection of representative items and their price collection.

The classification of products (goods and services)

Within the EU, expenditure needed for purchasing a set of goods and services by consumers are structured using the classification of individual consumption by purpose, abbreviated COICOP. In general, every type of good and service that consumers can buy is included in this classification. It is made up of 12 divisions, coded from 01 to 12 (see Box 1 for the full list), each of which is analysed in more detail — see Box 2 for a detailed example concerning expenditure on transport.

Box 1: Codes and labels for COICOP divisions

01 Food and non-alcoholic beverages
02 Alcoholic beverages, tobacco and narcotics
03 Clothing and footwear
04 Housing, water, electricity, gas and other fuels
05 Furnishings, household equipment and routine household maintenance
06 Health
07 Transport
08 Communications
09 Recreation and culture
10 Education
11 Restaurants and hotels
12 Miscellaneous goods and services

The set of weights Each good or service has different significance in terms of money spent by consumers (households). In order to add up (aggregate) the price change measured for each good and service, each price change must be given a relative importance taking into account the total sum of money spent (household expenditure). Price changes are therefore weighted according to the relative expenditure on these goods and services.

Consumers spend their money in different ways because they have different incomes and habits. Some households will spend more on food, others more on clothes, heating, or cars. If these differences for every household in a country are added together we can see the relative importance — the weight (see Box 2) — of each product category in that country. Of course, consumption patterns in another country are different and therefore the set of country weights will also be different.

Examples

While Markus in Germany likes to buy vegetables and cheese from the supermarket as part of his grocery shopping, Giulia in Italy prefers to purchase fruit, meat and pasta.

While Annika in Sweden spends a high share of her money on heating her flat, Miguel in Spain spends a greater share of his money on electricity for air conditioning and water for the vegetables he grows in his garden.

Tastes, products and prices change over time. For this reason weights are regularly updated.

Box 2: Detailed weights for transport — COICOP Division 07

Table 1 shows the categories within the transport division of COICOP for Spain and Poland. Rather than showing the value of consumption expenditure in euro or złoty, this table shows the relative importance (weight) of each of these transport headings within total household consumption expenditure. The weights are shown as a value which, when all of the weights for Divisions 01 to 12 have been put together, equals 1 000. In other words, these weights are calculated per mille, which is like percentages except that the total adds up to 1 000 rather than 100. For expenditure on transport as a whole, the weight in Spain in 2016 was 148.05 ‰ (approximately 14.8 %); in Poland the weight was 114.93 ‰ (approximately 11.5 %).

Table 1: HICP weights for transport, Spain and Poland, 2016
(‰; total for all items = 1 000)
Source: Eurostat (prc_hicp_inw)

Selection of representative items and their price collection

It is not practical for statistical offices to follow the price of every single product sold in their country on a continuous basis: this would take too much time and cost too much money. Consequently, for each category a sufficient number of individual items is selected as representative products and their prices are followed over time.

These individual items need to be defined precisely in order to be sure that the prices that are collected over different periods are related to exactly the same item. It is not enough to simply measure the price, for example, of a carton of fruit juice: detailed information is needed about the size of the carton, the manufacturer, the particular type of juice (such as its sugar content or additional ingredients); furthermore, information is also needed as to where the juice is bought, for example from which retailer.

Example

Returning to Markus, if he buys a chocolate bar from a late-night store or from a fast-food outlet he might expect to pay more per bar than the price paid when he purchases a family-size pack of chocolate bars from a discount supermarket. This is why the choice of outlet when measuring prices is also important, not just the choice of items.

Careful judgement is needed to ensure that items selected are genuinely representative of what people buy and under what conditions. This is why the selection of items and their precise specifications are reviewed frequently. As you might guess, this is not an easy task and some of the difficulties are outlined later in more detail.

Collectively, the selected items whose prices are surveyed each month may be referred to as a basket of goods and services. This can be understood as a shopping basket which is being filled with the same products every month and the prices of the items are added up. However, this should not be taken too literally: the number of prices of products collected every month is normally many thousands and so they would never fit in a shopping basket! The shopping basket of items is reviewed each year. Some items are taken out of the basket and some are brought in to make sure it is up to date and representative of consumer spending patterns.

Furthermore, calculating the index is more complicated than scanning items at a checkout counter and looking at the final sum. Carry on reading to find out why.

Every month statistical offices record prices for the selected representative items, ensuring that prices are collected from the different regions and outlets in each country. These prices are collected through price surveys, often by visiting shops and service providers and noting the price. In some cases prices may be collected directly by telephone or from tariffs from websites, for example for the price of an air fare.

Example

In Ireland, an average of 51 000 prices are collected each month for the harmonised index of consumer prices (HICP), while in Austria, an average of just over 40 000 prices are collected. Information on the price survey practices for each EU Member State as well as a few non-member countries is available in a set of national reports on the Eurostat website.

Calculation of price indices

A price index compares the prices of a set of products at different points in time. A price index shows how much must be paid for a set of products at one point in time relative to what would have been paid for the same set of products at another point in time. This point in time is taken as the reference of the comparison, the basis, and is set to 100.

Once the prices for each item in the 'basket of goods/services' have been collected, the next step is to calculate an index. This is done in 3 stages:

Stage 1: The prices observed in the latest period have to be compared with prices in previous periods, in order to see how they have changed. This is done by creating an index. This index can be made by comparing the prices in a month with the initial price at a certain point in time (a so called ‘reference period’). For example, if the price of a specific item is 10 % higher in a particular month than the price in the reference period, then the indexed value is 110, while if the price is 5 % lower in a particular month the index is 95.

Stage 2: In the next stage, an average of the indices belonging to the same category of products has to be calculated. For example, all indices related to fruit will be combined together to produce a price index for fruit.

Stage 3: Finally, the indices for the different product groups are combined using the weights described above (and for which an example is shown in Table 1). The weights are the shares of each expenditure category in total consumer expenditure. For example, in Spain petrol represents 28 ‰ (see explanation of ‰ in Box 2) of consumer expenditure and so the index for petrol will contribute 28 ‰ to the overall index in Spain. The total of these weights is the overall index, commonly referred to as the all-items index, which covers Divisions 01 to 12 of COICOP.

Now we have seen the different steps that have to be taken to collect prices and then to calculate consumer price indices.

However, when you hear or read about inflation most of the time it is usually mentioned not as an index, but rather as an inflation rate. Below we look at this rate in more detail.

Different kinds of inflation rates

If we calculate the rate of change for an index from one period to another we calculate the inflation rate, in other words, how much prices have changed (in percentage) between different periods.

As the calculation of the inflation rate can be based on comparisons over different periods, it is possible to analyse a number of different kinds of inflation rates:

  1. The monthly rate of change, which shows the rate of change between a month and the previous month.
  2. The annual rate of change, which shows the rate of change between a month and the same month of the previous year.
  3. The annual average rate of change, which shows the rate of change between one year and another. This rate can be calculated when a year has come to an end and shows an average index for the year.
  4. The 12-month average rate of change, which is an average of the monthly rate of change for each of the previous 12 months.


Box 3: Examples of the different types of rate of change for the EU-28

The monthly rate of change for the all-items index of consumer prices between July 2017 and August 2017 was 0.2 %.
The annual rate of change between August 2016 and August 2017 was 1.7 %.
The annual average rate of change between 2015 and 2016 was 0.3 %.
The 12-month average rate of change for all months from September 2016 to August 2017 was 1.4 %.

The overall inflation rate shows the change in prices for all items, in other words, the rate of change for the price of goods and services across the economy. However, many data users do not want to analyse just the all-items index, but want to look in more detail at price changes for different types of products. Apart from publishing indices (and rates of change) for the various products covered by COICOP, Eurostat produces a range of special aggregates that reflect particular needs. An example is the split of the all-items index into two parts, one for energy and one for all other products. This allows an analysis to be made of the overall development of inflation without the influence of the changes of energy, which can quite often reflect large fluctuations in the crude oil prices and so hide more subtle price changes for other products.

What are the challenges in measuring price changes?

As you may now understand, producing a consumer price index is not so easy. Furthermore, there are a number of other challenges that may be encountered when constructing a price index and trying to measure inflation; read on for more details.

Items that are selected for our representative basket of goods and services can change over time. For example, the ingredients used to produce a packet of biscuits might change, increasing or reducing the amount of fat or sugar, or the size of the packet could be modified so it contains less biscuits than before. When collected, prices are adjusted to take account of such quality changes.

Example

If the price of a packet of biscuits stays at EUR 1.20 but its size is reduced from 300g to 250g, this is treated as a change in quality: the price index should show an increase as there are fewer biscuits in the packet but the amount paid for the packet is the same. For some products a change into a smaller size may reflect an increase in quality, for example, as is the case for a laptop that becomes thinner and/or lighter.

In our example above, for the packet of biscuits it is quite easy to work out how much the quality has changed, but this is not always the case. Consider the case of a car manufacturer who produces a particular model of a car and after a year the engine power is upgraded from 105 to 110 horsepower. While it is clear that there has been a change in the quality of the particular car model, it is not so clear how much change this represents within the retail price for the whole car. Price statisticians have to deal with issues like these for complex products on a regular basis.

Another difficulty concerns new competing products that may enter consumer markets, while outdated products are no longer produced. Continuing with the example of a car manufacturer, what would happen if a particular model that had been selected for the price survey was no longer produced? An alternative model would need to be found and included in the price survey, either from the same manufacturer or from a different one. Sometimes completely new products arrive, for example home video cassettes in the 1970s, cellular mobile phones in the 1980s, or modern electric and hybrid cars in the last 10 years. In some cases it might be possible to include these immediately into the basket of goods and services for price collection, but in other cases it might be necessary to wait some time, until a major revision of the index is calculated, for example once a year or once every five years.


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