Workshop 4: Index numbers

Index numbers are used to quantify how much things are changing over
time.

They have a starting year called a base year where the index is
normally defined to have been 100 (although occasionally 1,000 is
used)

Index for a single item

This called a simple index or a price relative

Its value at time n is given by:

(Price at time n  Price at base time) × 100

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 Single item
Imports in 2012 were £10.89 billion
Imports in 2014 were £12.73 billion

Taking 2012 as the base year, what is the simple index for 2014?

Answer

(12.73  10.89) × 100 = 116.90

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 Group of items
Often we want to quantify how the price of a group of items has
changed.
The problem with simply divided the current price of the group now by
the price of the group in the base year (and multiplying by a hundred), is
that the group of items usually changes over time.

For example, in 2015 the

government added 
to the group for calculating
inflation
http://visual.ons.gov.uk/basket-of-goods-2015-whats-in-and-out

http://home.bt.com/lifestyle/money/mortgages-bills/the-2016-inflation-basket-sees-nightclubs-out-and-womens-leggings-in-11364046754338
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 Group of items
So calculated a before (2014) and after (2016) price is misleading as
different things are being bought.

Solution: Buy the same group of items on both occasions

Alternative 1: Use the original quantities at both times

This is the base period or Laspeyres index

Alternative 2: Use the new quantities at both times

This is the current period of Paasche index

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 Calculating the base period index

2015 price 2015 2016 price 2016

quantity quantity
Bread 50 3 52 5
Milk 42 2 42 1
Butter 140 1 150 2

Using base period quantities:

2015 cost = 50 × 3 + 42 × 2 + 140 × 1 = 374
2016 cost = 52 × 3 + 42 × 2 + 150 × 1 = 390

So base period index = (390  374) × 100 = 104

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 Calculating the current period index

2015 price 2015 2016 price 2016

quantity quantity
Bread 50 3 52 5
Milk 42 2 42 1
Butter 140 1 150 2

Using current period quantities:

2015 cost = 50 × 5 + 42 × 1 + 140 × 2 = 572
2016 cost = 52 × 5 + 42 × 1 + 150 × 2 = 602

So current period index = (602  572) × 100 = 105

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 Base period or current period?
Current period
• More relevant as it is about what we are buying now

Base period
• Easier to determine in practice as finding the quantities is hard – and
this has to be done every year in the current period index

• Having the quantities fixed and not changing every year allows
indices to be compared over a number of years, i.e. next year (2017)
the current period basket will have changed again

• Things that become very expensive will not be bought and so won’t
figure in the current period index – this seems unfair if we aren’t
buying them simply because they have become expensive

So not a clear winner between base period and current period

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 Calculating the inflation rate
Suppose the inflation index was 765 in September 2015, and was 780
in September 2016.

What was the % increase in prices over the 12 month period?

Answer

100 × (new index – old index)  old index =

100 × (780 – 765)  765 = 2.0%

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 Increasing in line with inflation
Suppose the inflation rate was 3.0% between January 2015 and
January 2016.

If an item costing £14.20 in January 2015 increased in price in line with

the inflation rate, then what should be its value in January 2016?

Answer

3.0% is the fraction 0.030

So we want to add 0.030 × £14.20 on to the initial price of £14.20

This is equivalent to £14.20 × 1.030 = £14.63

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 Decreasing in line with inflation
Going backwards:

Again suppose the inflation rate was 3.0% between January 2015 and
January 2016

If an item that cost £24.15 in January 2016 had increased in line with
inflation between January 2015 and January 2016, then what was its
price in January 2015?

Answer
We need to perform the reverse of increasing by 3%.
So instead of multiplying by 1.03, we need to divide by 1.03
January 2015 price = £24.15  1.03 = £23.45
NOTE multiplying by 0.97 is wrong as 1.03 × 0.97 does not equal 1
(It gives the wrong value £23.44, close but wrong)
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