How Should Inflation Be Measured?

In the previous few articles, a series of arguments has been made as to why the current way we use to measure inflation is not appropriate. A lot of the criticisms have received rebuttals from current economists. However, for a lot of criticisms, they do not have an answer at all. The usual reply received in this case is that “Yes, the current system for measuring inflation may be flawed. However, this is the best we know? Are there any suggestions or a system which can do the job better?“

Multiple systems have been proposed as alternatives through the years. None of these have been accepted by the mainstream economists and therefore they are only conjectures. However, no true critical analysis of inflation would be complete unless alternative solutions are offered.

This article will therefore focus on a proposed alternate way to measure inflation. This method will supposedly consume fewer resources and provide better results. Here is a gist of the system:

Understanding the Cause Effect:

As we have already elaborately discussed in the past articles, the rise in prices is an effect of inflation whereas an increase in money supply is the true cause. Majority of the problems of the incumbent system exist because attempts are made to measure the effect rather than the cause.

Measuring inflation would be a lot simpler process if changed in money supply were tracked down instead of tracking down the changes in prices. For one reason, only a handful of institutions are authorized to create more money. Hence obtaining data related to the quantum of new money created would be an easier exercise as compared to measuring the change in the price of each and every good!

Measure The Money Created By Governments:

The first institution that has been authorized to create more money is the government or an agency of the government called the Central Banks. In many nations, central banks are privately owned. However, since these institutions are so heavily regulated, it would be a valid assumption to consider them as a government entity.

Governments all over the world are by law required to maintain a record of the amount of new money that they have created over a period. They are also supposed to publish this finding for the common man. Hence, this information can be easily obtained.

Measure The Money Created By Banks:

Apart from the central bank, other private banks are also part of the monetary system. This means that they are also allowed to create new money when they lend it. Hence, apart from central banks, private banks are also involved in the creation of new money. However, they are not required to submit data in any prescribed format to government agencies. Hence, at the moment, this data is not publicly known and hence cannot be used in the calculation. However, the governments can easily make it mandatory for the banks to submit this data.

The bottom line is that data on money created is easily available at a very low cost and without any hassles if the government wants to obtain it. Compare this with the extensive survey which consumed massive amounts of time and money and still provided a poor approximation!

Measuring the Velocity of Money:

Now, we are aware of the quantity of money created. However, quantity is only one aspect of the money supply, the other aspect being the “velocity of money”. The data related to velocity of money can also be calculated based on the nominal GDP. The mathematics required for this calculation may be complex and beyond the scope of this discussion. However, what needs to be understood is that both quantity and velocity of the money supply can be easily obtained without even putting in even a fraction of the efforts that are usually spent on conducting surveys.

Using the formula developed by Milton Friedman’s monetary school of economics which is MV = PQ wherein:

M is the quantity of money available in the market

V is the velocity of money

Q is the quantity of goods produced. In this case, we can call it the nominal GDP

P is the price level of the economy.

Since we can derive M, V and Q quite easily, the formula can be solved for P and a general price level for the economy can be obtained. If we compare this price level with the previous year’s price level, we have our inflation numbers and we have obtained them using a much simpler and cost effective way!

Time- Series Averaging:

Lastly, techniques like time series averaging can be applied to remove any statistical bias and make the data more reliable and fit for analysis.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.