INFLATION

Inflation refers to a rise in prices of goods and services in an economy. When prices raise, the purchasing power of money declines; so inflation is said to reduce the value of money. The concept of inflation is simple, and widely understood, but the effect of inflation on different asset classes is subtle and often misunderstood.

In India, the two important measures of inflation – food inflation and headline inflation – are both based on the Wholesale Price Index (WPI). In any given week, the percent change of the WPI over the corresponding week in the previous year provides a year-on-year inflation figure called headline inflation (or just inflation). Thus headline inflation is influenced both by the latest value of the WPI and the corresponding value a year ago. If inflation was particularly high in the corresponding week last year, the current week’s headline inflation will tend to be lowered. The dependence on the preceding year’s WPI is called the base effect.

The hundreds of goods in the WPI basket include a large collection of foodstuffs including dozens of varieties of cereals, pulses, vegetables, fruits etc. This collection which has a weight of 14.34% in the WPI is called Food Article Index, commonly referred to as food inflation.