The Head and Tail of Wholesale Price

Index vs Consumer Price Index

Top of Form

...

Changes and movement in prices influence buying and selling decisions, and thus the economic
scenario. Hence the government, businesses, producers and consumers keep a constant check on
prices. However, given the large number of items that are sold and purchased every day, it is
difficult to keep track of all of them.
That is where price indices come in. They give a sense of the overall direction and trend in prices.
These indices are available for different sectors and for different groups of people.
There are indices based on prices in different markets or at different points of sales. Of the many
indices, two are of critical importance. The first is the Wholesale Price Index (WPI), which is
based on the price prevailing in the wholesale markets or the price at which bulk transactions are
made. The other is the Consumer Price Index (CPI), which is based on the final prices of goods at
the retail level. Both these indices are the weighted averages of prices of a specified set of goods
and services. The WPI is compiled and published by Office of the Economic Advisor on a weekly
basis while the CPI is compiled and published by the Labour Bureau on a monthly basis in India.
The CPI is published for rural, agricultural and industrial workers.
The use of price indices
These indices are used for various purposes, including for forecasting in businesses, used by
organizations and institutions for their analysis, and by the RBI and the government of India to
frame monetary and fiscal policy, etc. The WPI is used to measure inflation in India because of
the non-availability of appropriate CPI. It is used to deflate national income to calculate real
output in the economy. Also exchange rates are often adjusted on the basis of WPI. For example,
(hypothetical since India has flexible exchange rate) suppose the WPI index in India rises by
certain points (inflation). In order to maintain the purchasing power of the rupee vis-a-vis other
currencies, the rupee is depreciated. This would keep the price of Indian goods same in terms of
foreign currency, in spite of the inflation in India.
The cost of projects, price of supply of goods based on future contracts are often subject to
change with these indices. As these indices change, cost and supply prices are changed
accordingly. For example, an increase in the WPI may lead to increase in contract price of goods.
This role of indices will increase substantially in the future as economy matures and as new
markets develop for contractual trading. Also, often the wages and salaries are indexed to
inflation.
Problems with WPI
However, although the WPI is used in India for various purposes, there are flaws in it. For many
commodities like cars, wholesale markets may not exist. Also with increased competition, prices
based on costs, and the reduced role of government in trading of goods and services, it is difficult
to obtain prices and price data from private producers. The WPI doesn’t take the price of services
into consideration, which now accounts for 60 percent of the GDP. Also, it is too general and
cannot be used for specific purposes. For example, if an individual wants to know the trends in
office stationery products, then WPI may not capture the correct or complete picture. Some
commodities may have higher weights during a particular period and may not be consumed
during other. For example, woolen textiles are part of the consumption basket only for four
months in a city like Delhi. So a constant revision of weights is required in this regard. Another
problem is that the share of expenditure of commodities may change overtime. For instance, the
expenditure on computers, which were seldomly available before 1990s but now have a
significant share in the expenditure of an urban Indian. So the weights of these indices need to be
changed over time.
WPI and CPI in India
Inflation in India, measured by WPI, reached 12.9% on August 2, 2008 but fell sharply to 0.3% in
March 2009 and negative in June 2009. The reason for such high volatility was the primarily
fluctuation in international commodity prices. However, unlike WPI-based inflation, CPI-based
inflation remained high. It did increase with the WPI but did not come down proportionately
when wholesale prices fell. This indicates that intermediaries between consumers and wholesalers
or retailers or both have not passed on the low-cost benefits to the customers and so have enjoyed
increasing margins.
The graph clearly shows that for most of the time, the rate of growth of the CPI is more than the
rate of growth of the WPI, except when there are steep rises in the WPI during 2006 and 2008.
This may be due to the inability of retailers or intermediaries to pass on the increasing cost to the
consumers so quickly. This may also point out towards the existence of competition in the
markets.
Businesses Strategies and Price Indices
These indices help businesses and can prove to be an effective analytical tool for them. These
trends affect the economic policies and monetary policies of the government and RBI
respectively. High inflation rates are often followed by tight monetary policies. In India, the WPI
is related to interest rates as inflation is measured on the basis of the WPI. High inflation rates
may point towards increasing interest rates. However, other factors also come into play while
determining interest rates but inflation is a major one.
These indices play a role in affecting sentiments. Low inflation rates may lead to a sentiment
where investments financed through loans are deferred because of the expectation of lower
interest rates in the future. Certain expectations are formed based on the effects on overall
economy due to movements in these indices. For example, high inflation rates create a gloomy
sentiment about the economy and people generally tend to defer investments in that case. Also,
consumers tend to defer their heavy expenditures during inflation due to expectancy of fall in
prices. For instance, housing expenditure. However, other day-to-day expenditures like grocery,
energy, etc are generally not affected due to changes in these indices.
It should be noted that falling inflation never means that prices are falling. Only negative inflation
or a fall in these indices imply that prices are falling. Falling inflation (positive) or decreasing rate
of increase in these indices only imply that prices are rising at a slower pace. So falling inflation
for consumer does not mean that he/she has to pay a lower price in the future.
These indices also give insights whether holding an asset is justifiable or not. For example, if an
asset price rise is less than the inflation in the economy, then this may point out towards erosion
of purchasing power of the asset holder. In other words this means that an asset holder may not be
able to purchase the same quantity of goods in the next period if price rise in asset is
proportionately less than the rise in these indices by selling that asset. So investment in assets
must be made keeping this in mind. An absolute increase in the price of the asset does not
definitely mean that the asset holder has gained in real terms.
Also movements or changes in these indices affect the futures market. High inflation rate and
increasing trend may point towards higher price in future and hence higher prices of futures
contracts. Large movements or fluctuations in these indices often open up the opportunity for
arbitrage, which is making profit due to price differences in two markets (here different markets
refer to future and spot market).
If trends are analyzed (in graph also) then it would be clear that large margins or the gap between
the rate of increase of WPI and CPI could not be maintained for a long period of time because of
the existence of competition in most of the markets. Trends indicate that a fall in WPI inflation is
often followed by a fall in CPI inflation. So if the current situation is assessed, then it can be the
case that retailers or intermediaries would see a squeeze in their margins as the inflation gap
between the WPI and the CPI will eventually get reduced. Also, CPI inflation has already started
coming down. At the same time an increasing gap between the WPI and the CPI inflation may
attract interference by the government in some form of regulations or required policy changes to
check such trends.
So these indices at times may be inconsistent, may not guarantee fulfillment of requirements of
an individual and analysis based on these might not be complete or correct. However, these
indices provide useful tools for analysis and some conclusions could be drawn based on these.

Demand-Pull Inflation

What Does Demand-Pull Inflation Mean?

A term used in Keynesian economics to describe the scenario that occurs when price levels rise
because of an imbalance in the aggregate supply and demand. When the aggregate demand in
an economy strongly outweighs the aggregate supply, prices increase. Economists will often say
that demand-pull inflation is a result of too many dollars chasing too few goods.

Investopedia explains Demand-Pull Inflation

This type of inflation is a result of strong consumer demand. When many individuals are trying
to purchase the same good, the price will inevitably increase. When this happens across the
entire economy for all goods, it is known as demand-pull inflation.

Cost-Push Inflation Versus Demand-Pull

Inflation
Do you remember how much less you paid for things even two years ago? This increase in the
general price level of goods and services in an economy is inflation, measured by the Consumer
Price Index and the Producer Price Index. (see All About Inflation and What is inflation?) But
there are different types of inflation, depending on its cause. Here we examine cost-push
inflation and demand-pull inflation.

Factors of Inflation
Inflation is defined as the rate (%) at which the general price level of goods and services is
rising, causing purchasing power to fall. This is different from a rise and fall in the price of a
particular good or service. Individual prices rise and fall all the time in a market economy,
reflecting consumer choices or preferences and changing costs. So if the cost of one item, say a
particular model car, increases because demand for it is high, this is not considered inflation.
Inflation occurs when most prices are rising by some degree across the whole economy. This is
caused by four possible factors, each of which is related to basic economic principles of changes
in supply and demand:
1. Increase in the money supply.
2. Decrease in the demand for money.
3. Decrease in the aggregate supply of goods and services.
4. Increase in the aggregate demand for goods and services.
In this look at what inflation is and how it works, we will ignore the effects of money supply on
inflation and concentrate specifically on the effects of aggregate supply and demand: cost-push
and demand-pull inflation.

Cost-Push Inflation
Aggregate supply is the total volume of goods and services produced by an economy at a given
price level. When there is a decrease in the aggregate supply of goods and services stemming
from an increase in the cost of production, we have cost-push inflation. Cost-push inflation
basically means that prices have been “pushed up” by increases in costs of any of the four factors
of production (labor, capital, land or entrepreneurship) when companies are already running at
full production capacity. With higher production costs and productivity maximized, companies
cannot maintain profit margins by producing the same amounts of goods and services. As a
result, the increased costs are passed on to consumers, causing a rise in the general price level
(inflation).

Production Costs
To understand better their effect on inflation, let’s take a look into how and why production costs
can change. A company may need to increases wages if laborers demand higher salaries (due to
increasing prices and thus cost of living) or if labor becomes more specialized. If the cost of
labor, a factor of production, increases, the company has to allocate more resources to pay for the
creation of its goods or services. To continue to maintain (or increase) profit margins, the
company passes the increased costs of production on to the consumer, making retail prices
higher. Along with increasing sales, increasing prices is a way for companies to constantly
increase their bottom lines and essentially grow. Another factor that can cause increases in
production costs is a rise in the price of raw materials. This could occur because of scarcity of
raw materials, an increase in the cost of labor and/or an increase in the cost of importing raw
materials and labor (if the they are overseas), which is caused by a depreciation in their home
currency. The government may also increase taxes to cover higher fuel and energy costs, forcing
companies to allocate more resources to paying taxes.

Putting It Together
To visualize how cost-push inflation works, we can use a simple price-quantity graph showing
what happens to shifts in aggregate supply. The graph below shows the level of output that can
be achieved at each price level. As production costs increase, aggregate supply decreases from
AS1 to AS2 (given production is at full capacity), causing an increase in the price level from P1
to P2. The rationale behind this increase is that, for companies to maintain (or increase) profit
margins, they will need to raise the retail price paid by consumers, thereby causing inflation.

Demand-Pull Inflation
Demand-pull inflation occurs when there is an increase in aggregate demand, categorized by the
four sections of the macroeconomy: households, businesses, governments and foreign buyers.
When these four sectors concurrently want to purchase more output than the economy can
produce, they compete to purchase limited amounts of goods and services. Buyers in essence
“bid prices up”, again, causing inflation. This excessive demand, also referred to as “too much
money chasing too few goods”, usually occurs in an expanding economy.

Factors Pulling Prices Up

The increase in aggregate demand that causes demand-pull inflation can be the result of various
economic dynamics. For example, an increase in government purchases can increase aggregate
demand, thus pulling up prices. Another factor can be the depreciation of local exchange rates,
which raises the price of imports and, for foreigners, reduces the price of exports. As a result, the
purchasing of imports decreases while the buying of exports by foreigners increases, thereby
raising the overall level of aggregate demand (we are assuming aggregate supply cannot keep up
with aggregate demand as a result of full employment in the economy). Rapid overseas growth
can also ignite an increase in demand as more exports are consumed by foreigners. Finally,
if government reduces taxes, households are left with more disposable income in their pockets.
This in turn leads to increased consumer spending, thus increasing aggregate demand and
eventually causing demand-pull inflation. The results of reduced taxes can lead also to growing
consumer confidence in the local economy, which further increases aggregate demand.

Putting It Together
Demand-pull inflation is a product of an increase in aggregate demand that is faster than the
corresponding increase in aggregate supply. When aggregate demand increases without a change
in aggregate supply, the ‘quantity supplied’ will increase (given production is not at full
capacity). Looking again at the price-quantity graph, we can see the relationship between
aggregate supply and demand. If aggregate demand increases from AD1 to AD2, in the short run,
this will not change (shift) aggregate supply, but cause a change in the quantity supplied as
represented by a movement along the AS curve. The rationale behind this lack of shift in
aggregate supply is that aggregate demand tends to react faster to changes in economic
conditions than aggregate supply.

As companies increase production due to increased demand, the cost to produce each additional
output increases, as represented by the change from P1 to P2. The rationale behind this change is
that companies would need to pay workers more money (e.g. overtime) and/or invest in
additional equipment to keep up with demand, thereby increasing the cost of production. Just like
cost-push inflation, demand-pull inflation can occur as companies, to maintain profit levels, pass
on the higher cost of production to consumers’ prices.
Conclusion
Inflation is not simply a matter of rising prices. There are endemic and perhaps diverse reasons at
the root of inflation. Cost-push inflation is a result of decreased aggregate supply as well as
increased costs of production, itself a result of different factors. The increase in aggregate supply
causing demand-pull inflation can be the result of many factors, including increases in
government spending and depreciation of the local exchange rate. If an economy identifies what
type of inflation is occurring (cost-push or demand-pull), then the economy may be better able to
rectify (if necessary) rising prices and the loss of purchasing power.

Macroeconomic Analysis
When the price of a product you want to buy goes up, it affects you. But why does the price go
up? Is the demand greater than the supply? Did the cost go up because of the raw materials that
make the CD? Or, was it a war in an unknown country that affected the price? In order to answer
these questions, we need to turn to macroeconomics.
What Is It?
Macroeconomics is the study of the behavior of the economy as a whole. This is different from
microeconomics, which concentrates more on individuals and how they make economic
decisions. Needless to say, macroeconomy is very complicated and there are many factors that
influence it. These factors are analyzed with various economic indicators that tell us about the
overall health of the economy.

Macroeconomists try to forecast economic conditions to help consumers, firms and governments
make better decisions.
 • Consumers want to know how easy it will be to find work, how much it will cost to buy
goods and services in the market, or how much it may cost to borrow money.
• Businesses use macroeconomic analysis to determine whether expanding production will
be welcomed by the market. Will consumers have enough money to buy the products, or
will the products sit on shelves and collect dust?
• Governments turn to the macroeconomy when budgeting spending, creating taxes,
deciding on interest rates and making policy decisions.
Macroeconomic analysis broadly focuses on three things: national output (measured by gross
domestic product (GDP)), unemployment and inflation. (For background reading, see The
Importance Of Inflation And GDP.)

National Output: GDP

Output, the most important concept of macroeconomics, refers to the total amount of goods and
services a country produces, commonly known as the gross domestic product. The figure is like a
snapshot of the economy at a certain point in time.

When referring to GDP, macroeconomists tend to use real GDP, which takes inflation into
account, as opposed to nominal GDP, which reflects only changes in prices. The nominal GDP
figure will be higher if inflation goes up from year to year, so it is not necessarily indicative of
higher output levels, only of higher prices.

The one drawback of the GDP is that because the information has to be collected after a
specified time period has finished, a figure for the GDP today would have to be an estimate.
GDP is nonetheless like a stepping stone into macroeconomic analysis. Once a series of figures
is collected over a period of time, they can be compared, and economists and investors can begin
to decipher the business cycles, which are made up of the alternating periods between economic
recessions (slumps) and expansions (booms) that have occurred over time.

From there we can begin to look at the reasons why the cycles took place, which could be
government policy, consumer behavior or international phenomena, among other things. Of
course, these figures can be compared across economies as well. Hence, we can determine which
foreign countries are economically strong or weak.

Based on what they learn from the past, analysts can then begin to forecast the future state of the
economy. It is important to remember that what determines human behavior and ultimately the
economy can never be forecasted completely.

Unemployment
The unemployment rate tells macroeconomists how many people from the available pool of
labor (the labor force) are unable to find work. (For more about employment, see Surveying The
Employment Report.)

Macroeconomists have come to agree that when the economy has witnessed growth from period
to period, which is indicated in the GDP growth rate, unemployment levels tend to be low. This
is because with rising (real) GDP levels, we know that output is higher, and, hence, more
laborers are needed to keep up with the greater levels of production.
Inflation
The third main factor that macroeconomists look at is the inflation rate, or the rate at which
prices rise. Inflation is primarily measured in two ways: through the Consumer Price Index (CPI)
and the GDP deflator. The CPI gives the current price of a selected basket of goods and services
that is updated periodically. The GDP deflator is the ratio of nominal GDP to real GDP. (For
more on this, see The Consumer Price Index: A Friend To Investors and The Consumer Price
Index Controversy.)

If nominal GDP is higher than real GDP, we can assume that the prices of goods and services has
been rising. Both the CPI and GDP deflator tend to move in the same direction and differ by less
than 1%. (If you'd like to learn more about inflation, check out All About Inflation.)

Demand and Disposable Income

What ultimately determines output is demand. Demand comes from consumers (for investment
or savings - residential and business related), from the government (spending on goods and
services of federal employees) and from imports and exports.

Demand alone, however, will not determine how much is produced. What consumers demand is
not necessarily what they can afford to buy, so in order to determine demand, a consumer's
disposable income must also be measured. This is the amount of money after taxes left for
spending and/or investment.

In order to calculate disposable income, a worker's wages must be quantified as well. Salary is a
function of two main components: the minimum salary for which employees will work and the
amount employers are willing to pay in order to keep the worker in employment. Given that the
demand and supply go hand in hand, the salary level will suffer in times of high unemployment,
and it will prosper when unemployment levels are low.

Demand inherently will determine supply (production levels) and an equilibrium will be reached;
however, in order to feed demand and supply, money is needed. The central bank (the Federal
Reserve in the U.S.) prints all money that is in circulation in the economy. The sum of all
individual demand determines how much money is needed in the economy. To determine this,
economists look at the nominal GDP, which measures the aggregate level of transactions, to
determine a suitable level of money supply.

Greasing the Engine of the Economy - What the Government Can Do

Monetary Policy
A simple example of monetary policy is the central bank's open-market operations. (For more
detail, see the Federal Reserve Tutorial.) When there is a need to increase cash in the economy,
the central bank will buy government bonds (monetary expansion). These securities allow the
central bank to inject the economy with an immediate supply of cash. In turn, interest rates, the
cost to borrow money, will be reduced because the demand for the bonds will increase their price
and push the interest rate down. In theory, more people and businesses will then buy and invest.
Demand for goods and services will rise and, as a result, output will increase. In order to cope
with increased levels of production, unemployment levels should fall and wages should rise.

On the other hand, when the central bank needs to absorb extra money in the economy, and push
inflation levels down, it will sell its T-bills. This will result in higher interest rates (less
borrowing, less spending and investment) and less demand, which will ultimately push down
price level (inflation) but will also result in less real output.

Fiscal Policy
The government can also increase taxes or lower government spending in order to conduct
a fiscal contraction. What this will do is lower real output because less government spending
means less disposable income for consumers. And, because more of consumers' wages will go to
taxes, demand as well as output will decrease.

A fiscal expansion by the government would mean that taxes are decreased or government
spending is increased. Ether way, the result will be growth in real output because the government
will stir demand with increased spending. In the meantime, a consumer with more disposable
income will be willing to buy more.
A government will tend to use a combination of both monetary and fiscal options when setting
policies that deal with the macroeconomy.

Conclusion
The performance of the economy is important to all of us. We analyze the macroeconomy by
primarily looking at national output, unemployment and inflation. Although it is consumers who
ultimately determine the direction of the economy, governments also influence it through fiscal
and monetary policy.