Lesson 3.

Magnitudes in current prices, prices indexes and indicators of volume

1. Some useful tools in economic analysis: ratios, proportions, growth rates

In applied economics we are constantly working with data. We use them to analyse the
situation and evolution of many aspects of the economic reality, or to try to foresee how the
decisions we take may affect the future of the economy.
To do this, we use many tools, some of which are very sophisticated (macroeconomic models
or econometric techniques), but others that are very simple but need to be mastered and applied
correctly. In the following pages we will talk about some of these tools, which you already know
and which are very useful for presenting and analysing information.

1.1. Ratios (ratio o tasa en español)

Ratios are one number expressed in relation to another by dividing the first number by the
other. Thus, if Pepe’s salary is 3000€ and Juan’s salary is 1500, the ratio between Pepe's and Juan's
salary is 2 (Pepe earns twice as much as Juan). We can also use Pepe’s salary in the denominator:
1500 / 3000, the ratio is 0.5: Juan earns half as much as Pepe.
In many monetary systems the main currency is divided into 100 smaller units (cents), called
fractional currency. Thus the euro has 100 cents or the dollar 100 cents. In this case, a 50-cent coin
is equivalent to 1/2 or 0.5 euro. It is usually called fractional coinage, as its value indicates the
fraction or ratio in relation to the main coin whose value is 100 cents.
Some popular ratios are:
- GDP per capita: GDP divided by population. GDP of Navarra (2019) is 18,747,249 (thousands
of euros), and population is 656.5 (also in thousands): GDPpc = 21,332,864 / 656.5 =€. GDPpc
in Spain is 1,245,331 / 47,329 =
- Population density (population / km2): the population density of Navarra is 656,500 / 10,391 =
63.2, which is lower than population density in Spain, 47,329,000 / 505,936 = 93.5
- Female to male ratio (or male to female ratio): for Navarra, the ratio is 332,886 / 324,401 =
1.026, for every male there are 1.026 females.
- The Dependency Ratio: the number of people under age 15 plus the number 65 and over divided
by the number of people 15 to 64. It is very useful to study for example the substantiality of the
pension system. In Navarra, in 2019, the dependent population (0-15 and 65 and over) was
239,000, and the population in working age 410,000. The ratio is 0.58. For Spain, the ratio is
0.55. The larger the number, more dependent people per worker.
- Financial ratios, like Price to Earnings (per share) ratio, PER: Apple price is 114$ (29/09/2020),
earnings per share are 3.29, PER is 114/3.29 = 34.65

1.2. Proportions (and proportions in %)

Proportions are special kinds of ratios where the denominator is the total while the numerator
is a subpart of the total. This tells us what part the numerator is of the total. Thus, while the ratio of
females to males in Navarra is 1.026 females represent .5064 proportion of the total. Percentages
are just a form of the proportion based on 100 people. To calculate a percentage we simply multiply
a proportion by 100 (females are 50.64% of the total)

1
 Table 1. Proportions and percentages. GDP, Navarra, 2018

Source: INE, regional accounts. https://www.ine.es/dyngs/INEbase/en/operacion.htm?

c=Estadistica_C&cid=1254736167628&menu=resultados&idp=1254735576581#!tabs-1254736158133

1.3. Simple growth rates

When analysing variables that evolve or change over time, another widely used measure is the
growth rate or growth ratio of a period relative to the amount in the base year or the previous year.
These rates are usually expressed as a percentage (by multiplying the result by 100).
Imagine that your wage of 2000€ in year 1 becomes 2,200€ in year 2. This implies an
absolute increase of 200. To calculate it, it is necessary to know the absolute growth (200) and to
relate it to the magnitude taken as a reference, the value for the first year: 2000. Thus, an expression
that fits the previous definition would be: (Vt -V0)/V0 × 1001, in our example (2200-2000)/2000 *
100 = 10%
However, the unit of time to which the magnitudes refer can be very diverse (five years, years,
quarters, months, etc.), although annual figures are usually used in the analysis of macro-
magnitudes. Therefore, different growth rates can be calculated depending on the time reference
used. In this sense, average growth rates are sometimes calculated over a period, i.e. the growth rate
is calculated between two extreme years of a period and then divided by the number of years
considered, i.e. {(Vt -V0)/V0 × 100}/t.
Imagine now that your wage in year 1 is 2000€, and in year 5 is 2600€. The annual growth
rate (simple average) for this period is {(2600-2000)/2000 × 100} / 4 = 7.5% (in our example the
number of periods is 4, not 5: 5-1=4).

1.4. Compound growth rates

We want to calculate the magnitude of some indicators over a period of years when growth is
cumulative. For example, a shopping basket whose cost increases by 5 per cent per year (always
over the value of the previous year) after five years will not be 25 per cent higher, but slightly
higher (27.6 per cent). The increase in the price of a shopping basket would be a case of cumulative
growth, since price growth is incorporated each year into the value of the previous year.

Table 2. Compound growth rate of a basket of goods, 5% per year increase over the previous year
Cost of the basket Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
5% annual 1000€ 1050€ 1102,5 1157.625 1215.506 1276.281
increase 1000 × 1.05 1000 × 1.05 1000 × 1.05 1000 × 1.05 1000 × 1.055
2 3 4

1 A equivalent expression is [(Vt /V0) -1] × 100

2
 Sometimes we want to calculate the value of the variable after t years, given the current value
and if it grows at a x% growth rate (compound growth rate, x% over the value of the previous
year). For example, the population in Spain is 47,329 thousand. If it grows 2% (thus, 2%=x%) per
year during one century, the population would be… 324,856 (yes, more than 7 times current
population). The value is calculated 47,329 × (1.02) 100. The general formula is Final Value = Initial
Value × (1+ x%/100)n
With x% the growth rate in %, and n the number of periods
If we know the value of the variable in the current year, and the value after n years, and we
want to find out the annual compound growth rate in % (x%), we need to make this calculus:
Final Value = Initial Value × (1+ x% / 100)n
Then
Final Value / Initial Value = (1+ x% / 100)n
(Final Value / Initial Value)1/n = [(1+ x% / 100)n]1/n = 1+ GR% / 100
(Final Value / Initial Value)1/n - 1 = x% / 100
{(Final Value / Initial Value)1/n - 1 } × 100= x%
As example: If Spanish population in 2000 was 40,470,182 and in 2020 is 47,329,981, the
compound growth rate has been…
{(47,329,981 / 40,470,182)1/20 – 1} × 100 = 0.786%
As we will see in lesson 5, most of this growth is explained by immigration.
In finance it is very common to find this element: the compound interest. In compound
interest, interest is added to the capital over time. For example, money obtained from interest on a
bank account produces interest in the following periods, i.e. interest accumulates on the capital over
time.

2. Index numbers

Another way to express magnitudes in relative terms is to convert them into index numbers.
An index is a statistical measure that serves to compare a magnitude in two situations (temporal,
spatial, etc.), one of which is taken as a reference and is fixed arbitrarily. If temporal indexes are
elaborated, a period is taken as a reference, and if spatial indexes are elaborated, the magnitude in a
specific space is taken as a reference. For example, price index numbers show changes in wholesale
or retail commodity prices. These index numbers can therefore be used to compare the prices of one
commodity with those of others over different time periods or the prices of one part of the country
with those of others over the same time period.
The most common indices in economics are price index, (the index numbers show the
changes in the wholesale or retail prices of a particular product or several commodities), quantity
index (the index numbers measure changes in the volume or quantity of goods produced or goods
exported or imported), and value or aggregate index numbers (the index show the changes in the
market value of goods produced or sold).
When compiling the indices the first thing we need to do is establish the reference data (the
base year, or the reference country). Secondly, it must be considered whether the magnitude used is
a simple or complex one. In the latter case, it is necessary to decide how the different components
are to be aggregated and, where appropriate, the most appropriate weights.

2.1. Simple index numbers

Simple index numbers are elaborated when the analysis variable is a simple magnitude. To
compile the indices, if a time series is being considered, each quantity in the series is divided by the
quantity for one year taken as the base (reference) year and the result is multiplied by 100, since
they are expressed as a percentage, as in table 3, with an example of market value of the cars sold in

3
an imaginary country. This is an example of value index. The reference year has received the value
100. In the example we present the results with different base years.

Table 3. Market value of cars sold in Carland in different years: simple index numbers

2.2. Composite index numbers

Sometimes it is useful to express with a single magnitude, a single composite index, the
evolution of several similar associated variables, such as the average rise in the prices of the
products sold by a company or of all the goods bought by consumers, or the prices of the shares
traded in a market. If all the elements included in the index are of equal relative importance, it is not
necessary to weight them when compiling the index. However, if all the elements do not have the
same relative importance, it will be necessary to weight them when compiling the composite index.
In economics most of the indices include variables that have different relevance: the variables have
to be weighted.
But if we think that all the variables have the same relevance, the composite index is
calculated as an average (arithmetic, geometric, ...) of the simple indices, and therefore all the
magnitudes included in the index are assigned the same importance. If, for example, a price index is
being compiled, the expression of the index for period t, taking prices in period 0 as a reference,
would be as follows, if the average used is the arithmetic one:

where n is the number of products.

In table 4 we can see an example of composite price index, non weighted (or with the same
weight for all the items)

Table 4. Composite price index numbers

The composite index for 2016 using the arithmetic mean has been calculated like this:

(1.05/1+1.55/1.5+3.05/3) ((1.05/1)×100+( 1.55/ 1.5)×100+(3.05 /3)×100)

×100=
3 3

Dividing by “3” in this example is equivalent to saying that weight for each one is 1/3, the
same weight for all the goods.

4
 But in most situations the elements that are part of the index do not have to have the same
relevance. In table 5 we introduce an additional example, with just two but the first numerical
column includes the amount of sales of each product, or the amount spend by households in each
one of those goods.

Table 5. Composite price index with different weights

The amount spent by families buying cars is much higher than the expenses in electric bikes,
and the expenses in bikes are much higher than in motorboats. So each element can be assigned a
relative importance, a weight, equivalent to its share in total expenses or in the total amount of
sales.
Considering this weighting ωi (expressed as one), weighted composite indices are produced.
These are weighted averages (arithmetic, geometric,...) of the simple indices. If the formula used is
the one corresponding to the arithmetic average, we would have:

If we are using the geometric mean, we would have

For year 2016, the composite index with the arithmetic mean would be:

(102/100)×(100000 /117500)+(21/20)×(15000 /117500 )+(135/125)×(2500/117500)×100=102.51

And for the geometric mean:

100000 /117500 (15000 /117500) (2500/117500)
(102/100) ×(21/20) ×(135/ 125) ×100=102.50

We can see that the final index is much closer to the index for cars, because we spent most of
our income in cars. For most of us the evolution of prices of motorboats have very little relevance,
because we never buy one. Most indices (but not all) are calculated using arithmetic weighted mean.
In table 6 we use the same example, but this time we present information about quantities sold
or produced, and we calculate a volume index. This volume index will inform us about the
evolution, and growth, of quantities produced, but giving more weight to cars, because we use a
larger share of our income to buy them.

Table 6. Composite volume index with different weights for each good

5
 2.3. Laspeyres indices2

In the previous example we have avoided one relevant question: we have prices for three
years, but we have used sales for...what year? Sales, expenses are used to weight the individual
number index, giving more weight to cars than to bikes, and giving bikes more weight than
motorboats,
If “sales” were the sales of the first year in our comparative, we are using a Laspeyres index.
In the following pages, we understand value as the product of price multiplied by quantity: Vi,0 =
Pi,0× Qi,0
The Lasperyres Price Index for year t, with reference year 0, PIL,t uses this formula:

PIL,t

Weight for good i Price index for good i

With:
Qi,0 the quantity of good i produced/bought/consumed in year 0
Pi,0 the price of good i in year 0
Pi,t the price of good i in year t
Qi,t the quantity of good i produced/bought/consumed in year t
In other words, it quantifies the relationship between the initial quantities (quantities of year 0) at
current prices (prices of year t) and the same quantities (quantities of year 0) at initial prices (prices
of year 0). The result will therefore be the relationship between final and initial prices of the same
initial set of products.
We can also calculate a Laspyeres volume index (or quantity index):

QIL,t

We are using the same weights as in the Laspeyres price index. The Laspeyres volume index
quantifies the relationship between the current (final) quantities at prices of year 0 and the initial
quantities (quantities of year 0) at prices of year 0. The result will therefore be the relationship
between final and initial quantities of the same initial set of prices.

2 The names “Laspeyres” and “Paasche” are due to the two German economists who proposed using these indices at
the end of the 19th century, Ernst Laspeyres and Hermann Paasche.

6
 2.4. Paasche indices

But we could use different weights. The Paasche price index (PI p,t) uses as weights the share
of each element in the value of current quantities at base year prices. By simplifying, a relationship
is arrived at between the current prices and the initial prices of a current set of products. Its
mathematical expression is:

PIP,t

And the Paasche quantity index expression is:

QIP,t

Each of these indices has its advantages and disadvantages, so there is no clear choice in
favour of any of them. It is generally accepted that the Laspeyres indices tend to undervalue new
products for which demand increases, if their prices become more attractive to consumers, as the
products become established in competitive markets, while their weight in the basket has been
reduced by including them with the share they had in consumption in the initial period when they
were more expensive. On the other hand, the Paasche indices require the calculation of weights for
each period and are therefore somewhat more laborious.

2.5. Fisher index

As a compromise between Laspeyres and Passche indices, the fisher index is calculated as the
geometric mean of Laspeyres and Passche indices.

3. Real growth versus nominal growth

“Understanding National Accounts”, pp 1-22: “The A-B-C of macroeconomics consists of

distinguishing what part of the change in national accounts aggregates at current prices stems from a
change in the quantities produced and what part stems from a change in prices. Let us suppose, for
example, that the output of pasta is worth 100 000 dollars in the first year and 110 000 dollars in
the second. The macroeconomist will immediately want to know if this 10% growth (which may be
described as “nominal” or “in value” or, better still, “at current prices”) is due to an increase in the
quantity of pasta or to an increase in its price. An increase in quantity is good news, while an
increase in prices (“inflation”) tends to be bad news. Keeping in mind the aim of separating the
good growth (the quantities) from the bad growth (inflation), national accountants have developed
sophisticated methods for separating out movements in GDP “at current prices” into two
components: (1) an indicator of the change in quantity (the “real GDP” or, preferably, “GDP in
volume”); and (2) an indicator of the change in prices, called the “GDP deflator”

7
 There is a general trend towards continued growth in production in many countries of the
world due to the application of more labour, more skilled labour, as well as more capital and more
efficient technologies. The quantification of changes in a country's output over time is important as
an indicator of the extent to which the population's well-being varies. And the comparison of GDP
and its evolution (and also other magnitudes: GDPpc, GNI, GCF...) among countries can be very
useful for us to know who is doing better, and to act to improve the situation of the country's
inhabitants.
It is therefore necessary to know changes in GDP (and other magnitudes) over time and their
inter-spatial comparisons, and to have synthetic measures that adequately express such changes.
However, these comparisons are not without their difficulties.
Indeed, GDP is a flow of goods and services which are homogenised when considered in their
monetary assessment, at the prices prevailing in each period. It is also a mixture of items whose
composition changes over time, with the share of some products increasing or decreasing and new
products emerging. So do prices; the general price level may change and so may relative prices.
This creates significant limitations on comparisons.
The first and best known limitation is that growth in any macro-magnitude has two
components: one real or in volume (more goods and services), and one monetary (prices increase or,
less often, decrease). Therefore, the value of output in each year has to be deflated3, in order to
eliminate the change due to inflation and obtain only real or volume changes and not merely
monetary ones, such as those supplying the magnitudes at current prices or prices in force each year,
also called nominal magnitudes.
A second limitation relates to changes in the composition of the product over time and space.
This constraint is difficult to overcome and requires certain precautions to be taken, especially when
comparisons are made at great distances in time and space. Thus, the comparison of Spain's
standard of living between 1900 and 2020 is not reduced to a mere quantitative issue, but rather to
various options for the consumption of goods and services, which were largely non-existent in the
first year under consideration. The same should be said of the variation in relative prices over the
period. Therefore, long series have to be taken with care, as circumstances may have changed in the
time span under consideration. In this chapter we focus on temporal comparisons of macro
magnitudes. We will talk about spatial comparisons in lesson 4.
Look at table 7. We have an example with just one good, cars, and both volume produced and
prices for years 2014 and 2015.

Table 7. Price increase, volume increase: nominal vs real growth

The value of cars has increased 7.1%. But not all is “real growth”. Real growth=growth in volume
has been only 2%. The rest has been produced by growth in prices, 5%. We can see that growth in
value is almost, but not equal, to “real growth, 2%” + “price growth, 5%”. With large growth rates
the difference is bigger. This difference is due to the fact that we are missing the increase in prices
in a larger number or cars (the “multiplicative effect”, 0.02×0.05)
What is true is
1 + Value growth/100 = (1+ Volume growth/100) × (1+ price growth/100)
1 + 0.071 = (1 + 0.02) × (1+ 0.05) = 1 +0.05+0.02+0.02× 0.05

3 Deflate= to remove any part of the variable’s change that is attributable to price movements, arriving at a real, or
inflation adjusted, indicator.

8
This is the key concept to deflate. Rearranging terms, we have:
(1+ Volume growth/100) = (1 + Value growth/100) / (1+ price growth/100)
(1+0.02) = (1 + 0.071) / (1+ 0.05)
The implication is that if we know the value growth in current prices, and the increase in prices, we
can calculate the real increase of production. Or, alternatively, that if we now the values of
production in current prices, and the price index, we can calculate real growth.
Look at our example, and just imagine that you don’t know the real growth rate (volume growth),
but you know that value of production has been 1,000,000 and 1,071,000, with a 5% price growth
rate. To calculate real growth rate:
1+Real (volume) growth rate (per one)=(1,071,000/1,000,000 ) / (1+0.05) ==>Real growth rate=2%
We could also write, using the index numbers:
107.1 = (105 × 102) / 100 ==> 102 = (107.1 / 105) × 100
We can calculate the volume index for 2015 dividing the value index by the price index and
multiplying by 100.

4 Measuring inflation: CPI and Harmonised CPI

It has been pointed out that in the increase in GDP in each year, as in other magnitudes, there is a
real and a purely monetary component due to the variations in the prices of goods and services. To
the extent that a price index is available, applying it to the quantities valued at each year's prices
(current prices) could deflate these (i.e. remove the price increase from them) and thus calculate
changes in volume, or in real magnitudes or at constant prices. This requires a price index that
measures inflation in the economy.
Since inflation is a generalised increase in prices in an economy, with the consequent loss of
purchasing power of money, there is an interest on the part of the various actors to defend
themselves against it in order to maintain their relative status as consumers or as producers. To do
this, it is important to have a good indicator of it. What is this indicator? The correct answer should
be "make an indicator according to the use you intend to ×make of it". The usual use of the
Consumer Price Index (CPI) derives from employees' interest in maintaining the purchasing power
of their wages and therefore an indicator of the change in the prices of consumer goods seems
appropriate. Or the interest of the retired in an annual increase in pensions that could allow them to
buy the same basket of goods and services.
An entrepreneur who manufactures goods using an intermediate import input will need to look at
the price changes of some imports. Exporting entrepreneurs, on the other hand, must have
references from international markets in order to set the prices of their products, while for the likely
evolution of some of their costs, the variation in the CPI can provide them with information on
possible changes in wages, and they must also take other prices into account, such as wholesale
prices or the prices of capital goods or some imports.
Another problem with the various indices is the selection of the weights to be used, since, as we
have seen, they all have advantages and disadvantages. An additional problem, and one which is
difficult to solve, is that of changes in the quality of products. Some products become more
expensive because of their higher quality, so that sometimes price increases are not such but rather
expressive of the higher quality of the goods.
The following is a brief description of the most commonly used indices. In particular, the CPI, the
harmonised CPI, the core inflation indicator and the implicit GDP deflator are included.

9
4.1. The Consumer Price Index (CPI)

If a methodical citizen buys every month an identical list of goods and services for his
monthly consumption (food, clothes, bus tickets, petrol for his car...), he will normally find that he
has to pay a little more each month for the same basket of goods and services. For example, table
9.5 shows how the same basket of goods and services changes in value in 4 months from 500 to 525
euros. The changes can be expressed either as an index compared with the first month, which is
considered the base, or as percentage rates of change each month.

Table 8. The price of the basket of goods and services and the price index

Various institutions, such as governments or trade unions, as well as individuals, are interested
in the evolution of the prices of products on which citizens usually spend their income. To this end,
consumer price indices (CPIs) are compiled which, by means of an overall figure, aim to express
the average growth of consumer goods prices over a given period.
Each month, the average price increase for each of these items is calculated by taking prices
at a sample of sales outlets for different items representative of each category of goods and services.
Each of these price increases is weighted according to its share or weight in average consumer
spending in a given year, and the average price growth is thus calculated. It is a Laspeyres-type
price index.
In the case of Spain, the compilation of the consumer price index is the responsibility of the
INE, Instituto Nacional de Estadistica (National Statistics Institute). It began to be published in
1939 on the basis of 1936, and has undergone several actualizations since then (1958, 1964, 1976,
1983, 1992, 2002, 2007, 2012 and 2017). The current index is based on 2016 and entered into force
in January 2017. In 2002 there was mayor reform, with the aim to produce a more dynamic
indicator, as the weights can now be updated more frequently, in an attempt to bring the CPI more
closely into line with market developments than the index produced until then, whose weights
remained constant over ten years. With the new methodology, new products can be included in the
shopping basket when their consumption begins to be significant, as well as eliminating those that
are no longer consumed by households. In addition, the variation of the prices reduced and of the
offers began to be included, which allows the index elaborated to present a greater approach to the
reality.
Through the Household Budget Survey (HBS, or EPA-Encuesta de Presupuestos Familiares
in Spanish), elaborated by the INE, the expenditure of a typical family on food, clothing, leisure and
other goods and services is determined. This survey is carried out quarterly. It has replaced the
Basic Household Budget Survey, which was carried out every eight or nine years and used to update
the CPI weights until 2002. Each year the weights are updated using information from the HBS for
the latest available quarters.
The classification of goods and services whose prices are included in the CPI has been
adapted to the ECOICOP (European Classification of Individual Consumption by Purpose), the
harmonised nomenclature of the European Union, which is used by the Household Budget Survey.
Indices are published for 12 groups, 43 subgroups, 101 classes and 219 subclasses. Table 9 includes
the weightings of each group of goods and services in force in Spain in 2020, as well as those used
in some previous periods, which allows us to analyse the change which has taken place in the
consumption habits of the average Spanish family.

10
 In 2002, 108 new items were introduced and 95 disappeared. The number of municipalities
(up to 141) and establishments was increased from 471 to 484, so that the total number of prices
collected per month reached approximately 180,000. In the 2007 reform, the number of articles was
increased to 491, as some were incorporated, such as dietetic, homeopathic, myopia or aesthetic
products, and others were eliminated, such as upholstery fabric. In the last reform of 2016, online
video and music services, games of chance or single-dose coffee have been incorporated into food
products, and others that have lost relative importance in Spanish consumption have been
eliminated, such as brandy, video cameras or recordable DVDs, among others, so that the shopping
basket now has 479 items. In addition, a new treatment is introduced for seasonal products, in order
to improve the accuracy of the index produced. Prices are taken in 177 municipalities (52 provincial
capitals plus another 125 municipalities) in some 29,000 establishments. This means that each
month the total number of prices collected is around 220,000.

Table 9. CPI Weights Spain 2020

Source: INE: https://www.ine.es/jaxiT3/Tabla.htm?t=23720

Until 2002, a Laspeyres price index was produced on a fixed basis, i.e. the weighting of each
component in the base year was taken into account, and this weighting remained constant over a
relatively long period of time (around 10 years in the case of the Spanish CPI). The CPI was
therefore calculated as

CPI (before 2002)

Maintaining the fixed base has drawbacks, such as the structure of the weights becoming obsolete
as the index produced corresponds to a period further away from the base year and consumer
consumption patterns change. However, from 2002 onwards a chain-linked Laspeyres price index is

11
produced and, as a result, the weights are not kept constant but are updated periodically. This
implies that the base period, the reference period for prices and the reference period for weights do
not necessarily coincide.
The base period is the period for which the arithmetic average of the monthly indices is made equal
to 100. The year 2016 is the period for the system as it stands at the time of writing, and therefore
all subsequent indices (and until a further change in base) refer to that year.
The reference period for prices in year “t” is December of the year immediately preceding it, Dect-1.
They are calculated on the basis of the information provided by the Household Budget Survey for
the four quarters for the previous year, t-1.
Therefore, is now calculated in tow steps:
1) We calculate a CPI for each month in year t using as reference for the prices the price in
December year t-1.. For example, if we want to calculate CPI for October 2020, we calculate the
price index for every good and service as
Pi,Oct2020 / Pi,Pi,Dec2019
Pi,Oct2020 is “price for good i in Octpber 2020”
Pi,Dec2019 is “price for good i in December 2019”
The weights are the ones calculated with information form the HBS in 2019. For good i, the weight
is the same for all the monthly indices in 2020 (ωi,2019)
Q ×P i ,2019
ωi ,2019= n i ,2019
∑ Qi ,2019×Pi ,2019
i=1

And the index for October 2020, taking as “100” December 19:

( )
n
Pi ,Oct 2020
CPI Oct 2020 =∑ ω i ,2019× ×100
i=1 Pi , Dec 2019

2) But our reference year is 2016 ==> the average of the monthly indices for 2019 = 100.
We need to transform the value for October 2020. Just an example, imagine that the values that we
calculated almost one year ago for December 2019 was 105, and the value for October 2020 that we
have calculated for October 2020 in step 1 is 101:
If 100 is 105
Then 102 is x with x, the “chained index for October 2020”= 102×105 / 100 = 107.1
There is also an alternative approach: in our example, growth rate (%) between October-2020
and December -2019 is (107.1/105-1)=2%. If CPI in December 2019 is 105, then 105+ 2% of 105 =
105×1.02 = 107.1
Finally, it should be borne in mind that this index does not represent the price changes of all
household expenditures, as only the prices of goods and services that households use for
consumption are included. Therefore, the expenses that are included in GCF (the price paid for a
new house and the expenses derived from mortgage loans) are excluded, although some of this
expenses are included in CPI in other countries.
In table 10 we can see of the calculation of the chained index. With the HBS we calculate the
weights. The average of the prices in 2016 receives the index value 100. The index for December
2016 is calculates with the price index for each category, multiply by the weight taken from the
HBS of the previous year (2015). The calculus of the indices before chaining is:
Index Dec 2016 = {(49.5/49)*0.5+(20/19)*0.2+(4.8/4.8)*0.3}*100 = 101.56
Index Dec 2017 = {(51/49.5)*0.49+(22/20)*0.2+(5/4.8)*0.31}*100 = 104.78
Index July 2018 = {(55/51)*0.47+(19/22)*0.21+(5.3/5)*0.32}*100 = 102.74
And the CPI for each year, after chaining:
CPI Dec 2016: 101.56*100/100 = 101.56

12
 CPI Dec 2017: 101.56*104.78/100 = 106.41
CPI Jul 2018: 104.78*102.74/100 = 109.33

Table 10. Example of calculus CPI, base year 2016

4.2. The Harmonised Index of Consumer Prices (HICP)

Among the obligations of the Member States of Monetary Union, within the European Union,
is the achievement of a certain degree of price stability. On the basis of this commitment, the need
arose for a comparable indicator of price developments in the various countries belonging to the
Union.
Therefore, the statistical method required to produce a comparable price index produced by
each Member State, the so-called Harmonised Index of Consumer Prices (HICP), was developed. It
is an indicator of consumer price growth for a comparable basket of goods for all EU countries. The
HICP is compiled on the basis of the information used to calculate the CPI, but with some
adjustments (basically the removal of some products and the consequent change in weights) to bring
it into line with those obtained in other EU countries so that it is directly comparable. In each
country it covers the parcels which exceed one per thousand of the total expenditure of the national
shopping basket, and in the case of Spain this means considering around 97% of the CPI weighting.
Furthermore, since 1998 Eurostat has been calculating the Monetary Union Index of Consumer
Prices (MUICP) using a weighted average of the Harmonised Index of Consumer Prices (HICP) of
the countries which make up the European Monetary Union (EMU). This index is used to target the
monetary policy in the EMU:
“The ECB has adopted a specific strategy to ensure the successful conduct of monetary
policy. The ECB has defined price stability as a year-on-year increase in the Harmonised Index of
Consumer Prices (HICP) for the euro area of below 2%. In the pursuit of price stability, the ECB
aims at maintaining inflation rates below, but close to, 2% over the medium term”.
(https://www.ecb.europa.eu/mopo/intro/html/index.en.html)
Having a comparable indicator at EU level also allows the analysis of competitiveness
developments across EU countries through the inflation differentials in the HICP. As an example,
chart 1 includes the HCPI for Spain, the MUICP (the 19 countries which make up the European
Monetary Union in 2020) and for Germany, the largest economy in the EMU. This chart shows the
continuous loss of price competitiveness of the Spanish economy in each of the years from 1999
(the first year of the Monetary Union) to 2008, when the inflation rate was higher in Spain than the
average for the Monetary Union, and specially much higher than in Germany. Since then, the
situation has changed and in some of the last few years there have been slight gains in
competitiveness.

13
Chart 1. HCPI Spain, Germany and EMU-19: Spain is less competitive

Source: Eurostat, https://ec.europa.eu/eurostat/databrowser/view/prc_hicp_aind/default/table?

lang=en

4.3. Underlying or core inflation

The ECB has the objective of keeping HCPI below but close to 2% (annual growth rate), but
in the middle-long term. CPI and HCPI growth rate have large swings .There are trend, seasonal,
cyclical and transitory elements that generate those abrupt changes. The ECB and other economic
institutions are more concern with the long term trend that with this shocks. The underlying
evolution of the series, or core inflation, represents the path or trend around which the original
series oscillates. Therefore, it is an appropriate indicator to measure the problems that an economy
maybe facing in the long run, or if the distance to the ECB objective should worry us or is just a
transitory problem.
There are several ways to measure underlying inflation. The most simple way is to eliminate
the most volatile component of the index. For example, oil prices often exhibit large swings that can
produce, over the short term, substantial direct effects on energy prices. Similarly, unseasonal
weather can sometimes induce strong volatility in unprocessed food prices. To abstract from such
volatility, HICP inflation excluding energy and unprocessed food is often used as a measure of
underlying inflation. The ECB also tracks other indicators, but this is the most common.
In graph 2 we can see the difference both for the EMU and for Spain the annual growth rate
(every month calculated over the same month in the previous year) of HCPI and underlying
inflation from January 2016 (period 1) to August 2020 (period 56). We can see that there is a huge
difference in terms of variation in both variables, specially for Spain. One of the reasons for this
higher variation in Spain is that the weight for food and for fuel for personal transport is higher in
Spain than in the EMU.

14
Graphic 2. Annual growth rate HCPI (All items) and underlying(1) inflation, January 16-July2021
Source: Eurostat, https://ec.europa.eu/eurostat/databrowser/view/prc_hicp_aind/default/table?
lang=en

(1) Underlying defined as “Overall index excluding energy and unprocessed food”

5. GDP deflator and how to use price index to deflate

The GDP deflator is a price index that provides a broader picture of price changes than the
Consumer Price Index, as the latter only includes goods and services that make up household
consumption, while the implicit GDP deflator includes all components of final demand (individual
and collective final consumption, gross capital formation and net exports).
If GDP is available for the last year at current prices and also at the prices of the previous
year, the implicit GDP deflator is obtained by calculating the ratio of the two (current price
GDP/constant price GDP or otherwise nominal GDP/real GDP). This is a very useful measure of
inflation, as it includes all the goods and services which make up this macro-magnitude
(multiplying each result by 100 is obtained in the usual form of indices).
We have seen in section 3 the difference between “real growth” and “nominal growth”. In
order to compare GDP from different years to find out real growth, we must eliminate the impact of
prices changes. This is done using the same prices for both years. If we use the prices of the last
year, we are calculating a Paasche price index. GDP deflator is a Paasche price index:

GDP deflatort

This is a price index, quantities are both equal in numerator an denominator, only prices change.
The values of GDP at current prices (nominal values) for a number of years divided by the
deflators for each year (expressed as an index) and multiplying each result by 100 gives the series of
GDP at constant prices (real values). In table 10 we can see Spain GDP in current prices and in
constant prices for 2015-2019.

15
 Table 10. Spain GDP and current and constant prices, index numbers and GDP deflator

Therefore, to remove from a magnitude at current prices (1113840, Spain 2016) the price growth
effect (that it has been juts 0.32%, the price index goes from 100 to 100.32), we have to divide by
the deflator and multiply by 100: 1113840/100.32*100 = 1110255.
Real magnitude = Nominal Magnitude / price index × 100
Thus, if a series of deflators are available in the form of price indices, dividing the quantities
at current prices by the deflators and multiplying the result by 100 gives values at constant prices. In
the example shown in table real GDP has been expressed in the prices of year 1, which is taken as
the basis.
Deflators are also developed for each of the components of GDP, taking into account that
there are three ways (demand, supply and income) of calculating this magnitude, and that the
components can therefore be of three types. In other words, there is a deflator for individual
consumption, but also one for the VA in the industrial sector and other for compensation of
employees.
On of the main drawbacks of this price index is that, unlike the CPI, is obtained several
months after the end of the year, and is subject to the usual macroeconomic revisions. We call it
“implicit” because the INE doesn’t really publish de deflator. The Institute publish the results for
GDP at current prices, the volume index, and growth rates both in current prices and in volume (real
growth rate), and the deflator has to be derived from this information. Thus, tou will not be able to
find information about GDP deflator like in table 10 in the web pages of INE.

BIBLIOGRAPHY

This lesson has been written using as references this books:

- Lequiller, F. and D. Blades (2014), Understanding National Accounts: Second Edition, OECD
Publishing. http://dx.doi.org/10.1787/9789264214637-en

- Muzoz, C. Iraizoz, C. and Rapun, M (2020); Introducción a la economía aplicada. Magnitudes y

cuentas económicas. Civitas-Thomson Reuters.

The data about the Spanish accounts have been taken from INE. These are the web pages:

INE (2017): Índice de Precios de Consumo. Base 2016 Metodología. Madrid https://www.ine.es/
metodologia/t25/t2530138_16.pdf
https://www.ine.es/jaxiT3/Datos.htm?t=30678#!tabs-tabla

16
https://www.ine.es/dyngs/INEbase/en/operacion.htm?
c=Estadistica_C&cid=1254736164439&menu=resultados&secc=1254736157760&idp=125473557
6581

https://www.ine.es/jaxiT3/Tabla.htm?t=30682&L=1
https://www.ine.es/dyngs/INEbase/en/operacion.htm?
c=Estadistica_C&cid=1254736165305&menu=ultiDatos&idp=1254735576581

Information about HCPI have been taken from EUROSTAT:

Eurostat: “Measures of underlying inflation for the euro area”, Published as part of the ECB
Economic Bulletin, Issue 4/2018:
https://www.ecb.europa.eu/pub/economic-bulletin/articles/2018/html/
ecb.ebart201804_03.en.html#toc1

Eurostat: “Statistics explained: HICP methodology”: https://ec.europa.eu/eurostat/statistics-

explained/index.php?title=HICP_methodology#Computation_issues

The methodology for the elaboration of CPI in English can be found, for example, in:

https://www.ons.gov.uk/economy/inflationandpriceindices/methodologies/
consumerpricesindicestechnicalmanual2019

17