Which of the following statements is/are correct?

1. A price index captures the change in the average price of a constant basket of commodities.

2. If the price index takes values 100, 110 and 121 in three consecutive years respectively, then the inflation rates in the 2^nd and 3^rd years are 10% and 21%  respectively.

Select the correct answer using the code given below. 

The correct answer is 1 only.

Key PointsUnderstanding Price Index and Inflation Rate Calculation

• A price index is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.
  • Changes in the price index over time reflect the economy's inflation rate.
• The statement that a price index captures the change in the average price of a constant basket of commodities is accurate. It's a fundamental tool in the economics field to measure the cost of living and inflation.
  • Hence, statement 1 is correct.
• Regarding the inflation rate calculation, it is derived from the price index by calculating the percentage change in the index over consecutive periods. If the price index moves from 100 to 110, the inflation rate for that period is calculated as [(110-100)/100] * 100 = 10%.
  • Similarly, if it then increases to 121, the inflation rate for the next period is [(121-110)/110] * 100 = 10%, not 21% as mentioned.
• The error in the second statement arises from a misunderstanding of how to calculate percentage changes correctly. The inflation rate is based on the relative change from one period to the next, not the absolute change from the base period.
  • Hence, statement 2 is incorrect.

Additional Information

• Inflation is a measure of the rate at which the overall level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
• Understanding the Consumer Price Index (CPI) and Wholesale Price Index (WPI) are crucial for analyzing inflation. These indices provide insights into price changes from the perspective of consumers and wholesalers, respectively.
  • The CPI measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
  • WPI measures the changes in the prices of goods sold and traded in bulk by wholesale businesses to other businesses.
• Monetary policy tools such as interest rates are often adjusted based on inflation trends to ensure economic stability.