measurement of inflation: Choice of price index

the measurement of inflation, as defined in the previous section ( a persistent upward movement in the general price level ), involves three main problem :
1-The problem of choosing the price index which is to represent " the general price level ";
2- The problem of measuring the extent of the upward movement in the chosen index over any specified period of time;and
3- The problem of measuring variations in the speed of the upward movement in the chosen index over the specified time period.
In this and the two following sections we shall consider each of these three problems in turn. The discussion will be developed in the Australian context,but it will be applicable, with small modifications, to most advanced industrial economies.
In most countries the choice of a price index to represent the general price level in the measurement of inflation is quite wide. In the case of Australia the main possibilities are as follows:
(a) the consumer price index(C.P.I.)
(b) some component of C.P.I.;
(c) either of the wholesale price indexes (W.P.I.)or some component of either;
(d) the implicit deflator of G.N.P.;
(e) the implicit deflator of some category of gross national expenditure (G.N.E.);
(f) the implicit deflator of non-farm G.N.P.at factor cost.
The problem to be considered in this section is the problem of deciding which of these six indexes is the most appropriate. We shall approach this problem by first listing the characteristics of a price ind. which would be ideal for the purpose in hand (the measurement of inflation)and then examining each index to determine the extent to which it possesses these characteristics.
The first characteristic of an indeal index is that it would relate only to commodities produced within the economy or group of economies whose inflation is being measured. For example, if we are attempting to measure the extent of inflation in Australia or in Western Europe, we should like the price index which we use for the purpose to relate only to commodities produced within Australia or within Western Europe,as the case may be. Thus an index which covers imported,as well as
domestically produced commodities,is less than ideal for the purpose of measuring inflation.
Second,an ideal index would be comprehensive in the sense that it would relate to all goods and services produced within the economy,or economies,being studied. For example,an index which relates only to retail goods would fall short of the ideal in the present context,as would one relating,say,to goods consumed by wage-earners.
Third, an ideal index would take proper account of improvements in the quality of the various commodities covered by the index, whether they be goods or services. In other words,it would be recognised,in constructing the index,that over a ten-or fifteen-year period,say,the nominal rise in the price of a commodity may considerably overstate the true rise in price. For example,suppose that in constructing an index it is assumed that the rise in the price of medical services between any two points in time is equal to the rise in the cost of medical services between the same two points in time. Such an index would be less than ideal because,in constructing the index, no allowance is made for improvements in the quality of medical services. Because of quality improvements the true rise in the price of medical services will be less than the nominal price rise, that is less than the rise in cost. By equating the two the index would overstate the rise in the price of medical services over any period, which means that it would overstate the rise in the general price level over that period and in turn the extent of inflation as we have defined it the previous section.
The final characteristic of an ideal index is that it would not be affected by price increases which are temporary, in the sense that they are likely to be reversed at some time in the future, for example price rises which can be attributed to unfavourable weather conditions or to government fiscal action. This requirement is necessary because of the way in which inflation has been defined According to our definition reversible price increases are not part of the upward movement in the price level which constitutes inflation,and for this reason we would like them to have no affect on the index which is to be used to represent the general price level in the measurement of inflation.
We shall now consider each of the indexes in the list presented earlier,in the light of these four requirements, with a view to deciding which of them is the most appropriate for the purpose of measuring inflation.