Problems: Measurement of Inflation

There is a general saying in the business world, “What cannot be measured cannot be managed!” This is true of inflation as well. Hence, governments are supposed to constantly measure the amount of inflation in the economy. The idea is to have a control chart approach to keep inflation in check. This means that the government may expect inflation to remain at 3%, let’s say they decide the range is 2% to 4%. So now the government will take measures at regular intervals.

If the result falls within the range, no action will be taken. If the result is less than 2% or more than 4%, then immediate corrective action will be taken. Now, this may seem surprising but less than a certain amount of inflation is also considered dangerous in the present economic system. It is considered as the leading indicator of deflation, which must be avoided at all costs.

In the previous article, a step by step explanation was provided regarding the process of calculating inflation. The process being followed is what is believed to be the best alternative we have if the knowledge present in the mainstream media are to be believed. However, there are a whole lot of problems associated with calculating inflation the way it is being done now. Some of these problems cripple policy making as well. In this article, we will critically analyze the procedure that we had mentioned in the previous article and bring out some of its shortcomings.

Expensive and Time Consuming:

The basic and most obvious problem is that the current process of measurement of inflation is both expensive as well as time consuming. A lot of resources need to be deployed to track down the prices of goods across the length and breadth of any country. Not to mention that for every type of good, there are several qualities. Hence, procedure needs to be defined as to how exactly the prices need to averaged to get a fair picture.

But even apart from that, the problem with this procedure is apparent. The problem of inflation is a top priority and needs immediate action. The governments cannot afford a huge time lag between finding out the extent of inflation problem and the time taken to initiate corrective measures. Ideally all governments need a process which consumes relatively less resources and is quick. However, the current belief is that this is the best alternative that we have.

Goods Need To Be Updated:

The second issue faced while using price indexes as a barometer for inflation is that fact that there are a certain number of goods called the representative goods that are included in them. Now, we may recall that due to technological advancements a lot of products have become obsolete and a lot of new products have indeed come into existence. Consider the fact that the Walkman, Video Cassette Player etc are all gone. Instead we have MP3 players and computers and many other goods which never existed before.

Hence, ideally the basket of representative goods must be updated to reflect this change. However, this is very difficult to accomplish given the extreme bureaucracy. As a result, often obsolete goods are left on the list and the inflation numbers calculated as a result end up being skewed.

Weights Need To Be Updated:

Also, each good has been assigned weights. Over the period of time, the relative importance of this good as compared to others may increase or decrease. An ideal system should have a mechanism of reflecting this increasing or decreasing importance via the weights. However, in many cases, this becomes difficult to achieve. Once again government bureaucracies are not in favor of making any change to the price index. Usually government employees do not have the initiative to proactively make the required changes. Once again the result is an extremely outdated and misleading inflation index.

Which Index Is Relevant?

Also, government officials face difficulty while deciding which index should be used while policy making. When there are separate indexes for rural and urban customers, it is likely that these indexes may not always agree. Many times the urban index may depict a different story as compared to the one being depicted by the rural index. In this case, it is difficult to decide which data is relevant and take a decision accordingly.

Impossible Goal:

In the light of all these problems, using the current system of measuring inflation to enable the policymakers to have correct data and make appropriate decisions is impossible. There is no way that the time and money required for this exercise will be cut down in the near future. If anything at all, the costs are likely to increase.

Also, while providing government workers with more powers to change the goods and the weights which comprise the price index may seem like a solution, it isn’t! The government employees could also use this flexibility to cover up bad news. For instance if the price of A rises, they could reduce the weight assigned to A or they could omit A from the calculation altogether! Either ways manipulation could be possible. Also, if the different years’ data is based on different years’ indices, the numbers become incomparable, making any analysis impossible until extensive changes have been made to the data.

In short, the current system of inflation measurement is riddled with issues and is in urgent need of an overhaul.

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Managerial Economics