Measuring inflation through stochastic approach to index numbers

This study attempts to estimate the rate of inflation in Pakistan by the stochastic approach to index numbers by allowing systematic changes in relative prices. This approach provides not only point estimate but also confidence interval for the rate of inflation. There are two types of approaches to index number theory namely: the functional economic approaches and the stochastic approach. The attraction of stochastic approach is that it estimates the rate of inflation in which uncertainty and statistical ideas play a major roll of screening index numbers We use CPI data covering the period July 2001--March 2008 for Pakistan and find that if prices of individual commodities are widely dispersed then the level of uncertainty for measuring the rate of inflation will be very high. We find that the rate of inflation was changing significantly from month to month and by applying stochastic approach to index numbers we gained some level of confidence that our estimated range will contain the true parameter of the rate of inflation.