Q.1 What are index nos. and what is their importance/utility?

A.1 Index no. are the nos. which are used to measure how a time series changes
over time. The changes are measured with respect to a base period whose value is
taken to be 100, and the value of the current period is expressed as a percentage
of the base period value.
Two types of Index No. are : Price indices and Quantity Indices.

Importance/Utility
• They show the average changes in the price or quantities of a group of
commodities (Specialized averages)
• WPI represents the price changes in the wholesale commodities.
• CPI is used as a measure of inflation and is known as cost of living index.
• Index nos. are constructed for exports-imports, agricultural output,
employment-unemployment etc. These index nos. are called as Economic
Barometers.

KEY POINTS
• Simple aggregative index nos. assign equal importance to various
commodities while computing the changes in the price level thus allowing
the commodity with the higher price to dominate the index.
Moreover it fails the unit test (it is influenced by the units of the
prices/quantity of the various commodities)
• Laspeyre’s rule focuses on maintaining the standard of living of the base
year while Paasche’s rule focuses on the standard of living of the current
year, the two indices are thus biased (in terms of the law of demand or not).
• Weighted average of relatives has limited applicability due to difficulty in
determining objectively the weights for the prices/quantity.

TEST OF ADEQUACY OF INDEX NOS.

• Units Test: The units in terms of which the prices are given should not affect
the value of the price index. (Only simpl.agg fails)
• Time Reversal Test: An index should be reversible in time.
Eg. If price level in 2006 was twice as compared to 2005 then the price level
in 2005 should be half as compared to that in 2006.
P01 x P10 = 1
Fisher’s Index Passes (Laspeyre and Pasche Fails)

• Factor Reversal Test ; The product of price and quantity index should yield
us the value index.

P01 x Q01 = V01

Fisher’s Index Passes (Laspeyre and Pasche Fails)

• Circular Test: An extension of the time reversal test to 3 time periods.

If price level in 2005 was twice of 2006, and price level of 2006 was twice of
2007 then 2007’s price index would be 1/4th that of 2005.

P01 x P12 x P20 = 1

Simple agg. And Simple avg. of Price Relatives (GM) satisfy this test
(Fisher’s fails this test)