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