Chapter 18
Index Numbers
Summary chart of the chapter
Index
Numbers
Construction
Types of Index
Numbers
Price Quantity Value
Process Usefulness Formulas
Index Index Index
Tests of
Shifting
Deflating a Adequacy
and
series
Splicing Unit Time Factor Circular
test Reversal Reversal Test
Test Test
Meaning
Average
Relative (or %)
Change
Over time (sometimes space)
Example and Interpretations
Price Index of year 1 on year 0 P01 = 125
Price Index number of the current year is 125%. Base year Price Index
is always taken as 100.
Prices in the current year have become 125% of base year.
Prices in the current year have increased by 25% from the base
year.
Prices in the current year have become 1.25 times of the prices in
the base year.
Types of Index Numbers
Index Numbers
Price Indices Quantity Indices Value Indices
Agricultural
CPI WPI Industrial Production
Production
Simple (Price Composite
Relatives) (Average)
Simple Weighted
Average Average
Issues involved
Selection of data: If the purpose is to calculate cost of living, capital goods
should be ignored and only consumer goods are considered.
Selection of commodities: Over a period of time the commodities consumed
change so selection should be carefully done.
Selection of Base Period: Base year should be a normal year not affected by
extreme events and it should be relatively recent.
Selection of Average: Averaging plays crucial role in construction of Index
numbers since it is a composite number. GM is the best measure for Index
number but in most of the cases AM is used because of its simplicity. Weighted
Average is more popular than Simple Average.
Selection of Weights: Importance to each commodity should be given
according to its proportion in total expenditure of the consumer of some year or
some such sensible weights should be used.
Choice of variables: Depending upon the purpose, data of prices is used
whether wholesale prices or retail prices for example.
Selection of Formula: Cost of Living Index is Laspeyre’s formula for example.
Methods of finding Index Numbers
Methods or Formulas
Simple Weighted
Aggregative Average Average (Same as
Aggregative Laspeyre)
Weight of
Laspeyre Marshall-
Passche Fisher Bowley some typical
(CLI) Edgeworth
year
Formulas of Price Indices Methods
σ 𝑃1
Simple Aggregative: σ 𝑃0
× 100
𝑃
1 ×100
𝑃0
Simple Average of Price Relatives:
𝑛
Weighted Average of Price𝑃 Relatives (Same as Laspeyre if Base year expenditures are taken
1 𝑥 𝑃0 𝑄0
σ 𝐼𝑊 𝑃0
as weights): σ𝑊
𝑥 100 = σ 𝑃0 𝑄0
× 100
σ 𝑃1 𝑄0
Laspeyre’s Cost of Living Index (L): σ × 100
𝑃0 𝑄0
σ 𝑃1 𝑄1
Passche (P): σ × 100
𝑃0 𝑄1
𝐿+𝑃
Bowley (Arithmetic Mean of Laspeyre and Passche) (B):
2
Fisher’s Ideal Index Number (Geometric Mean of Laspeyre and Passche) (F): 𝐿 × 𝑃=
σ 𝑃1 𝑄0 σ 𝑃1 𝑄1
σ
× σ
× 100
𝑃0 𝑄0 𝑃0 𝑄1
σ 𝑃1 𝑄1 +𝑄2
Marshall-Edgeworth (M-E): σ × 100
𝑃0 𝑄1 +𝑄2
σ 𝑃 𝑄𝑛
Weights of some typical year n: σ 1 × 100
𝑃0 𝑄𝑛
1Τ
𝑃1 𝑃1 𝑃 𝑛
Simple GM of Price relatives:
𝑃0
× 𝑃0
× 𝑃1 ⋅ … 𝑛th 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦
0
Important formulas of Quantity and
Value Indices
𝑄1
Quantity Relative Q01 = × 100
𝑄0
σ 𝑄1 𝑃0
Laspeyre’s Quantity Index = σ × 100
𝑄0 𝑃0
σ 𝑄1 𝑃1
Passche’s Quantity Index = σ × 100
𝑄0 𝑃1
σ 𝑄1 𝑃0 σ 𝑄1 𝑃1
Fisher’s Quantity Index = σ 𝑄0 𝑃0
×σ × 100
𝑄0 𝑃1
σ 𝑃1 𝑄1
Value Index = σ × 100
𝑃0 𝑄0
Chain Index and Link Relatives
Limitations of Index Numbers
Sampling errors are possible because entire population survey can
not be possible or practical.
Not all items can be covered in their construction, but only selected
items represent the entire basket.
Multiple methods used in calculation or construction of index
numbers create confusion.
Usefulness of Index Numbers
To know the cost of living of certain class of people
To deflate the data (to convert nominal wages into real wages)
To forecast economic activities and trends
To help researchers in their research
To help Government in making their policy decisions
To help businesses to forecast demand or future sales and revenue
To find out trend, cyclical variations, seasonal variations and
irregular variations in Time series analysis
Deflating a series
Over a period of time increment is given to the employees by increasing their salary or
giving them Dearness Allowance to compensate them for the increased prices of
goods and services they buy and consume. In order to maintain their same standard of
living, their actual nominal income must increase at the same rate at which prices have
increased (Inflation rate).
Thus we can say that actual or nominal income includes the effect of inflation and
hence even if it is more than the base year, we can not say that the standard of living
must have improved. If the nominal income increases at a rate more than the inflation
rate, then only we can say that the standard of living must have improved in real sense.
So Real income (in terms of their actual purchasing power or ability to consume the
same quantity of goods and services as in the base year) of the income earners can be
calculated only by removing the effect of inflation and therefore we deflate (divide by
Price Index of that year) any time series (like salary). Since price rise effect is removed
now, this imaginary income or expenditure value is actually the product of current year
quantity purchased and base year prices. The income is said to have increased in real
terms only if one can buy more quantities of goods in current year at the same prices as
those of base year.
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒
Real Income or Deflated value of an income series = =
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟
𝑃 𝑄
= 𝑃11 1 = 𝑃0 𝑄1
𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝑜𝑓 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 ൗ𝑃0
Example of Deflating nominal
wages
Shifting of base
Backward and Forward Splicing
Tests of Adequacy
Unit Test: Index number should not get affected by change or conversion of the unit
or scale of unit of any of the commodities in the basket. Simple Aggregative formula
doesn’t pass this test.
Time Reversal Test: Index number of current year on base year should be reciprocal of
the Index number of base year calculated on current year.
Condition for passing of test (without multiplying by 100): P01 X P10 = 1
Fisher and Marshall-Edgeworth formulas pass this test.
Factor Reversal Test: Price Index number of current year on base year and Quantity
Index number of current year on base year should multiply to give the Value Index.
σ 𝑷𝟏 𝑸𝟏
Condition for passing of test (without multiplying by 100): P01 X Q01 = V01 = σ
𝑷𝟎 𝑸𝟎
Only Fisher’s ideal Index number formula passes this test and that’s why only it is known as
ideal index because it passes both TRT and FRT.
Circular Test: Two Index numbers through an inter connecting period taken as base
should multiply to the Index number of current year calculated on the original base
year.
Condition for passing of test (without multiplying by 100): P01 X P12 = P02
Only Simple GM formula and AM with fixed weights pass this test.
