Index Numbers


In order to measure the rate of inflation it is necessary to measure the rate at which the prices are changing. This is done by an index of price (index number). Standard of living is the level of goods and services that a person can afford to consume. Price is the relation between a quantity of money and a quantity of goods and services. Prices indicate the relative value of goods and services in terms of money at a particular time. Since money itself is used as measure of money, value of money can be seen, only indirectly through the prices of other goods. Therefore, the level of prices of goods and services is showing the value of money.  A price rise means a fall in value of money and vice versa.  Price of a commodity is the amount of money that has to be given for it. The value of money is the quantity of goods it will buy.  So value of money is the purchasing power
Index number is a statistical device to measure inflation. It measures differences in the magnitude of a group of related variable during a period in comparison with the level of the same phenomenon on some previous period.
There are many Uses of Index numbers. Index numbers are economic barometers, it measure and compare changes in price, it study the trends and tendencies, it is useful to take decision. It provides guidelines to government to make policy decisions.  Changes in purchasing power of money affect the prices of all commodities, but this may cancelled or neutralized by several other forces. A change in value of money is not the only reason for the changes in prices.   Some of such reasons are measurable and others are not.  Index numbers are used to study the effect of such factors which cannot be measured directly.  
Price index is constructed on the basis of the information obtained from survey on family expenditure.  The average price of all the items selected in the first year is called as base year and is given the number 100.  If on average, all the prices of the selected items rise by 25% over the following year the price index for the second year will be 125. If in the next year price rises on average 10%. The price index will stand at 137.5. (125×10%=12.5, 125+12.5=137.5)  Thus on average prices have risen by 37.5% over years 1 and 2. Construction of index number is as follows.


 The index number resulting from this simple index calculation would be misleading because each of the commodities is given equal importance. In the real world people spend large proportion of their income on commodities of more importance. [Changes in the price of food items are of much greater relevance to large number of people than change in price of luxuries ornaments]
 It is possible to overcome this difficulty by using a system of weights.[In the above table – 50 percent of total consumer spending is devoted to commodity A,  30 percent to commodity B and 20 percent to commodity C. Weights are now allocated in the proportions 5:3:2 ] The price indices for each year are multiplied  by appropriate weights and the average obtained by dividing the total of these weighted indices by the total of the weights  Construction of weighted  index numbers is as follows.


 Weighting of the commodities has produced a different result here than that obtained in the Construction of Simple index number [in the previous page].  This is due to the weight given proportional to its importance in the general pattern of consumer spending.   
 There are some limitations for Index Numbers.  Index number is an attempt to measure changes in retail prices of an average family may not always correct.  The pattern of consumer spending is always changing in accordance with the income, tastes, fashion and so on, but the weights given may not change.  New raw materials and new products are continually coming into use causing shift in demand and consumer’s spending pattern.  Moreover consumers shopping habit also change greatly due to changes in retail trade such as introduction of super markets and hyper markets etc.
                                                                       Back to Home Page Click here