Word for the day: Diffusion index (DI)

There are a number of economic indicators that attempt to gauge human sentiment. Of course, peoples feelings, hopes and expectations cant be measured directly, so the surveyor often has to ask qualitative questions, not quantitative. Nonetheless, their sentiment has to be quantified and expressed as a number in order to be useful. One of the ways this goal is commonly done is through a diffusion index. These are used for example in the widely reported Purchasing Managers Indices (PMIs) announced around the world every month. The ZEW and Ifo indices in Germany, the Bank of Japans short-term survey of economic trends (tankan), and the Michigan University Consumer Sentiment Index are other examples of diffusion indices. A diffusion index measures the degree to which a change in something is dispersed, spread out, or "diffused" in a particular group. If all members of a group (the sample population) are asked if something has changed and in which direction, they will answer in one of three ways: it hasnt changed, it has increased, or it has decreased. Or, as in the case of the Ifo index, they can characterise their situation as "good", "satisfactory" or "poor" and their expectations for the next six months as "more favourable, "unchanged" or "more unfavourable. In their simplest form, diffusion indices are calculated by taking the percentage of people who say something has increased (e.g., sales or new orders) or improved (e.g. ease of finding jobs) or is more favourable (e.g., banks lending attitude) and subtracting the percent who say it has decreased or worsened or is less favourable. So for example if in a sample of 100 people, 20 say that sales have increased over the previous month, 10 say they have decreased, and 70 say there is no change, then the diffusion index would be 10. Note that it would also be 10 if 40 say it has increased and 30 say it has decreased. Of course, there are a lot of variations on this way of calculating diffusion indices. For example, in the widely watched PMIs, respondents indicate each month whether particular activities (e.g., new orders) for their organizations have increased, decreased, or remained unchanged from the previous month. The PMIs are calculated by taking the percentage of respondents that report that the activity has increased ("better") and adding it to one-half of the percentage that report the activity has not changed ("same") and adding the two percentages. Using half of the "same" percentage effectively measures the bias toward a positive (above 50%) or negative index. As an example of calculating a diffusion index, if the response is 20% "better," 70% "same," and 10% "worse," the DI would be 55% (20% + [0.50 x 70%]). By doing it this way, a reading of 50% for the PMI indicates "no change" from the previous month.

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