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An Introduction to Index Numbers

An index number is a tool economists use to track changes in prices, quantities, or economic activity over time
- Index numbers are a way of standardising economic data so as to make easier comparisons between countries

How to create an index

Step 1: Select the items

Determine what items or variables you want to measure such as prices or other economic indicators

Step 2: Select the base period

Choose a base period against which all future observations will be compared
This period typically serves as the reference point with an index value of 100

Step 3: Data collection

Gather data for the selected items or variables over time, including during the base period

Step 4: Weighting (if applicable)

Assign weights to each item based on their relative importance
This step is common when constructing composite indices like the Consumer Price Index (CPI)

Step 5: Index calculation

Multiply each item’s value by its weight (if applicable) and sum them up to obtain the index value for the current period

Step 6: Interpretation

Analyse the index values to understand trends or changes in the measured variables over time

Worked Example

An economy’s GDP increased from $500 billion in 2017 to $540 billion in 2019. Using 2016 as the base year, establish the value of the index for GDP in 2018 and comment on its significance

Step 1: Calculate the Index for 2019 using the formula

$Index space for space 2019 space equals space fraction numerator Real space GDP space 2019 over denominator Real space GDP space base space year end fraction space straight x space 100 Index space for space 2019 space equals space fraction numerator $ 540 space billion over denominator $ 500 space billion end fraction space straight x space 100 Index space for space 2019 space equals space 108$ [1 Mark]

Step 2: Comment on the value

The value of the GDP has increased by 8 percent in this period

Calculating Inflation

Inflation is the sustained increase in the general price level in an economy
The UK uses two inflation indices and each is calculated slightly differently
- The consumer price index (CPI)
- The retail price index (RPI)

Consumer Price Index (CPI)

The Consumer Price Index (CPI) measures changes in the average level of prices paid by households for goods and services during a specific time period

The Construction of the CPI

Steps	Explanation
Step 1: Selection of goods and services	A selection of 700 goods and services are selected as a typical ‘household basket’ each month. This is determined through household expenditure survey Each year, some goods and services exit the basket and new ones are added
Step 2: Collection of price data	Usually, on a monthly basis, prices for each item in the basket are collected from a 150 locations across the country The number of goods in the basket varies from country to country, e.g. the UK has 700 ‘goods’ in their basket and Singapore has 4,800
Step 3: Weighting	Goods and services in the basket are weighted based on the proportion of household spending E.g. More money is spent on food than shoes, so shoes have a lower weight in the basket The price x weighting determines the final value of the good or service in the basket

Using the CPI to calculate inflation

The formula used to calculate the CPI is

$CPI space equals space fraction numerator Cost space of space basket space in space current space year over denominator Cost space of space basket space in space base space year end fraction cross times 100$

Once the index number has been calculated, the percentage difference between two index numbers represents the rate of inflation

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