Let’s start with a love story. You are a young college guy, and as young guys are supposed to, have fallen in love with a girl. Naturally, you want to be with her and burn your (daddy’s) petrol in this pursuit. You are neither good in arts nor in sports (you have a promising career in IT), so the only way to impress her is to pay her and her friend’s canteen bills. You also talk to her on mobile for hours. If she doesn’t entertain that, you talk about her to your (equally boring) friends. Whatever, the mobile company gains. Shortly, you find out each month, you need 30 liters of petrol, buy 50 canteen meals and make 300 minutes of call. Two lines of economics – say one litre petrol costs Rs. 50, one canteen meal Rs. 25 and one minute call Re.1. So total is 1500+1250+300=3050. Ok, come back on the love(?) story.
One year pass, you still make no progress. But our dear Manmohanji raises petrol prices to Rs.60 to prevent losses for oil companies (haha, Indian Oil Corporation announced 130% dividend on May 2010). Our canteenwala has seen enough campus life to know that you won’t mind paying some more for her and her friends, so he jacks up his meal price to Rs.30. Only our much-maligned Ambani is nice enough to reduce the price of a call to 75 paise. So now your monthly total is Rs.3525. This is 15.5% over our old (last year’s value of Rs.3050. This 15.5% is your inflation, showing how much the prices have changed over a period of one year.
Usually with inflation is specified a term like CPI-AL, CPI-IW, CPI-UNME. These are not Naxalite organizations operating out of Eastern India, but stands for Consumer Price Index (Agricultural Labourer, Industrial Worker or Urban Non-Manual Employee). Our “love inflation index” used 3 items (petrol, canteen meal and phone call), but these ones have about 400+ items, which will further be increased to 600+ items shortly(and you thought love was the most complex thing?). The actual number of items and the weightage of each item depends on which index is used. For example, an urban non-manual employee, closest to the ‘middle class’, spends more on services/rent, than an agricultural laborer who will spend more on food; hence CPI-AL will have more “weightage” on food than CPI-UNME. The weightage is mathematically calculated so that on the year the index is formed, the index total will be 100. (Details of the actual weightages can be found here [PDF]).
Then there is the official WPI – the Wholesale Price Index. This is based on prices at wholesale level and not retail. Since wholesale prices are calculated before the entry of various ‘middlemen’/hoarders/agents who push up prices, the WPI may have no relation to what you and I may buy from our local store. Luckily, someone has found it out in 2009, after 62 years of independence. So efforts are being made to base official figures on some index other than WPI – hopefully, we will get one within the next 62 years.
How is the index calculated?: In our love example, the weightage of petrol:meals:mobile in the first(base) year will be 1500:1250:300 or 49:41:10, to make it 100. From the second year, the ratio of current price to base price is multiplied by the weightage to get the index value.
(60/50)*49 + (30/25)*41 + (0.75/1.00)*10 = 115.5. Notice this is the 15.5% (over the base of 100) which we calculated earlier. The same method is used for further years. So, by knowing the index values at any two instance of time, the rate of inflation between them can be calculated.