Index Numbers chapter 7

Describing changes in price over time: over several years.

Index numbers:
An index number is always referenced back to a base year which is always given a value of 100. Subsequent figures (the next years) are then scaled in relation to the base year, so an index gives the change since the base year.

Suppose we have the price of an item for each year over a four year period:
Year 1 2 3 4 Price 2.00 2.20 2.40 2.90

What is the increase each year?

Year 1 2 3 4

Price 2.00 2.20 2.40 2.90

Calculation (2 * 100/ 2) ( ( ( * * * / / / ) ) )

Index 100

We could choose Year 1 as the base year

Changing the base year

Because an index is just scaled, changing the base year mathematically is just a case of maintaining the ratio between the numbers. For example:
Year 1 2 3 4 r e 2.00 2.20 2.40 2.90 Index 1 100 110 150 200
I 2 90.91 100.00 109.09 131.82

3 83.33 91.67 100.00 120.83

4 68.97 75.86 82.76 100.00

To make year 2 the base year, divide each figure in Index 1 by 110 (the new base year) and multiply the result by 100:
100 v 100 110

Whilst the mathematics of changing the base year are easy, for a real index number the decision to start from a new base year is a major one. Most index numbers consist of a basket of goods and this may have to change when the base year changes. Ideally we would like the base year to be typical: having no unusual features but this rarely happens. Base years are usually changed when the index has large numerical values since this may lead to confusion between the points change in the index and the percentage rise in the data.

Linking Index Series

Although there are practical reasons for changing the base year of an index, we usually want a continuous series to work with. We therefore need to be able to link series together.
Year Ol Index New Index New I ex Ol I 89.94 1 152 96.45 2 163 100 169 3 169 100 185.9 4 110 194.35 5 115 202.8 6 120

The key to this is having the old and new values of one year here year 3

The ratio is 169 to 100 Or 1.69 to 1 Use this on the other index numbers

Nominal & Real Change

Index numbers allow us to remove inflation from monetary figures,and therefore show real change. For example, if the cost of renting has increased by % in years, but the rate of inflation has been 8% over the same two years, then the rents have increased, in real terms, by %. Similarly, if the price of DVDs has increased by % in the last year,whilst inflation has been at 6% then the price of DVDs has decreased by 3% in real terms.

Simple Price Index

A simple price index relates the current price to the base year price, using the formula: P
n

Po
Year Price
Index 100

v100

150 200 300

30 v100 20 40 v100 20 60 v100 20

9

Simple aggregate price index

In most cases we are interested in the prices of a basket of goods, and not just one item. We therefore need an aggregate index. 1. Add up columns 2. Use
Item A B C P i eY0 1. 2. 5. P i eY1 1.10 2.30 5.60 P i eY2 1.15 2.35 5.7

n o

v 100

8.00
100

9.00
112.

9.20
115

9 v 100 8
10

Average Price Relatives Index

A price relative is a simple index of the price of an item, in relation to the price of that item in the base year:
Item A B C Price Yr0 1.00 2.00 5.00 Price Yr1 1.10 2.30 5.60 Price Yr2 1.15 2.35 5.70

PR Yr0 100 100 100

300

PR Yr1 110 115 112

337
112.33

PR Yr2 115 117.5 114

346.5
115.5

1. Find PRs for each item 2. Add up columns 3. Find the average

100

Note that we get different answers this time 11

The indices so far have either dealt with a single item or assumed that all items are of equal importance. This is obviously not true! We need an index which can deal with a basket of goods and take account of the relative importance of the items in the basket.

Laspeyres Index
This is a base-weighted index, i.e. it uses the quantities bought in the base year to assess the relative importance of the items
Item Quant Yr0 Price Yr0 Price Yr1 Price Yr2 A 50 1.00 1.10 1.15 B 20 2.00 2.30 2.35 C 5 5.00 5.60 5.70 PoQo 50 40 25 P1Qo 55 46 28 P2Qo 57.5 47 28.5

115

129 112.2

133 115.7

1. Multiply each price by the quantity in Year 0

100

2. Add up each column 3. Use PnQ0

P Q
0 0

v100

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Problems with Laspeyres:

Laspeyres index assumes that the same amount of each item is bought every year. If I bought a radio one year, the index assumes I bought one the next year. kg of oranges in Po, the index If I bought assumes I bought the same amount every year, when in reality if the price went up, one might buy less.

Paasche Index
This is a current-weighted index, i.e. it uses the quantities bought in the current year to assess the relative importance of the items
I A B C Qu nt Yr0 50 20 5 Qu nt Yr1 55 21 5 Qu nt Yr2 60 23 4 ri Yr0 1.00 2.00 5.00
P Q 60.5 48.3 28 136.8 PoQ 55 42 25 122

ri Yr1 1.10 2.30 5.60

P2Q2 69 54.05 22.8 145.85

ri Yr2 1.15 2.35 5. 0

PoQ2 60 46 20 126

The formula is:

PnQn v100 P0Qn

Note the structure of this. We need to find Sum P1Q1 and Sum P0Q1

136.8 v100 ! 122 112.1311

145.85 v100 ! 126

115.754

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Other indexes.
These indices can be turned around to make quantity indices: Laspeyres Quantity Index =

Paasche Quantity Index =

P Q v100 P Q P Q v100 P Q
0 n 0 0 n n n 0

or become a Value Index

P Q v 100 P Q
n n 0 0

15

Retail Prices Index

      The RPI is the main index which measures inflation in the UK It is about retail prices, so doesnt include all spending It uses a basket of goods It uses weights based on what people spend on average, from FES But these are changed each year Looking at weights over time shows changes in spending patterns

 For up to date information see the web site at:

http://www.ons.gov.uk

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http://www.fxwords.com/r/retail-price-indexpri-uk.html
Retail

Price Index measures changes in the prices of goods and services bought for household consumption in the UK. The RPI takes a large sample of retail goods including food, tobacco, household goods and services, transport fares, motoring costs, clothing, and leisure goods and services. An increase in the index means that prices have increased on average (inflation) while a decrease means that prices on the whole have fallen (deflation).

Internet.