Inflation and Index Number

INTRODUCTION An index number is a statistical measure which is designed to express changes in a variable or a group of related variables under two different situations. They are usually expressed in percentage form.

The comparisons may be between the periods of time, between places or other characteristics. We can also say that an index number is a number which indicates the level. of a certain phenomenon at any given time in comparison with the level of the same phenomenon at some standard time. They are constructed with reference to a base period and thus very useful in comparing changes over different time periods.

For example if we say that index of a certain industry in 2004 was 125 with the base year 2000, it would imply that the production has increased by 25% in 2004 as compared to 2000. Such an index computed for only one item is called a univariate index. If we like to construct an index for the industrial sector as a whole, it will be a composite index because here a number of variables have to be combined. A few definitions of index number are given, below: 1. A special type of average which provides a measurement of relative changes from time to time or from place to place". Wesell and Willett.

2. "An index number is a stastical measure designed to show changes in a variable or group of related variables with respect to time geographical location or other characteristics such as income, profession-etc. "-Spiegel Uses of index numbers The theory of Index Numbers is widely applied in economics and business. They serve the following purposes.

(i) Index numbers are very useful in studying trends of a series over a given period of time and thus facilitates forecasting. (ii) Index numbers provide the basic criteria to make policies. iii) Index numbers help in measuring the purchasing power of money. (iv) They are used in computing real wages through the process of deflating. (v) Index numbers are Economic Barometers.

Indices of prices, output, foreign exchange, bank deposits etc. act as barometers to find out ups and downs in the general economic conditions of a country. Barometers are used to measure atmospheric pressure and index numbers are called economic barometer as they measure the pressure of economic and business behaviour. Index number may be classified in terms of the variables that they measure.They are generally classified into three categories.

1. 'Price Index Number The most common index numbers are the price index numbers. They study changes in the price level of commodities over a period of time. They are of two types: (a) Wholesale Price Index Number They depict changes in the general price level of the economy.

The first series of the index number was constructed by the Government of India in 1947 with August 1939 as the base year. (b) Retail Price Index Number They reflect changes in the retail prices of different commodities. They are constructed for different classes of consumers. .

Quantity Index Number They reflect changes in the volume of goods produced or consumed. Some of the quantity index numbers are-index number of agricultural production, index numbers of industrial production, indices of exports and imports etc. 3. Value Index Number They study changes in the total value (Price x quantity), for example, index number of profits or sales is a value index number. Problems in the construction of index numbers Since the basic approach in the construction of all types of index numbers is the same, we shall discuss the problems of constructing price index.The construction of index numbers involves the consideration of the following' important points.

1. Purpose There must be precise statement about the purpose of constructing index numbers. All index numbers will not serve the same purpose and there is no all purpose index number the other steps in the construction of index number will mainly depend on the purpose. So, the purpose for which the index number is constructed should be clearly stated. 2.

Selection of base period The base period is a previous period with which comparison of some latter period is made.The index for the base period is taken as 100. The following points should be borne in mind while selecting a base period. (a) Base period should be a normal period i.

e. , it should be free from all sorts of abnormalities such as floods, famines, earthquakes, strikes, epidemics etc. i. e. , base period should be a period of economic stability. But in practice, it is rarely obtained.

Usually the base period is of one year and is called the base year of the index number. (b) Whether fixed base method or chain base method is adopted should be decided before constructing index numbers. c) Base period should not be a period of distant past as due to the passes of time new commodities enter the market and old one disappears. (d) Base period should not be too short or too long. 3. Selection of Commodities In constructing any index number it is not possible to include all the items or commodities.

The commodities should have the representing capacity. A sufficiently large sample of commodities should be selected to obtain reliable index numbers but that would become costly. Again too small number of items will not reflect the information properly.As such number of commodities should neither be too large or too small. While selecting sample of commodities instead of random sampling.

judgement or purposive sampling should be applied. Those commodities should be included which are stable in quality and preferably should be standardized because comparison of the relative change is possible only if the quality of the commodities does not change much. 4. Collection of Data The raw data for the construction of index numbers are the prices of the selected commodities together with their quantities used. The data may be either primary or secondary depending upon the purpose.

The price of a commodity varies from place to place, market to market, shop to shop and even within the same shop from customer to customer. It is not possible to obtain prices from all places where a particular commodity is sold. Even from selected places, prices cannot be collected from all shops. A selection of representative places and of representative persons has to be made.

The task of collecting data can be done either by appointing staff or by giving to task to some individuals of that particular locality. If necessary, it is better to appoint more than one person in each selected place.The information published in standard newspapers and journals or magazines about the prices can also be considered. 5. Selection of Average The prices of various commodities have to be combined to arrive at a single index and this is done with the help of averages.

For constructing an index number any average such as AM, median, mode, OM and HM can be used. Among all the averages, OM is the only average that gives appropriate results in case of relative measurement of changes. Thus, although GM is difficult to compute it gives quite satisfactory results. Hence GM is generally used in the construction of index numbers.

Since each of the averages has its own merits and demerits, the selection of an average is also a problem for constructing index numbers. 6. Assignment of Weights The assignment of weights to selected commodities is very important. 'Weight' means the relative importance of the items. All the commodities included in the index number are not of equal importance. Thus, different weights are to be assigned to different items in order that the Index is true representative, For example, the importance of rice is no doubt more than cosmetics, There are two methods of constructing index numbers (i) Unweighted method and (ii) weighted mehtod.

In case of unweighted method the weights 'of all the commodities are equal and is taken as 1. There are two basis of weighting: (i) Quantity of the items consumed, (ii) Value of the items consumed. When quantity forms the basis of weight it is called 'quantity weighting' and in case of value it is called 'value weighting'. Weights may be either explicit or lmpicit.

Explicit weighting implies that weights are laid down on the basis of importance of items. Implicit weighting implies the inclusion of a commodity in an index number more than once. 7.Selection of Appropriate Formula There are various formulae for constructing index numbers and each formula has its own limitations. The selection of formula mainly depends on the purpose of constructing index number and the collected data. Hence selection of appropriate formula is also a problem in the construction of index number.

Generally base year is denoted by the symbol '0' and current year by' 1 '. So, P0 = Price of the commodity in the base year P1 = Price of the commodity in the current year, q0 = Quantity in the base year q1 = Quantity in the current yearP01 = Price index number for the current year compared to the base year. Index numbers may be classified as below: CHARACTERISTICS OF INDEX NUMBERS * Index numbers are specialised averages. * Index numbers measure the change in the level of a phenomenon. * Index numbers measure the effect of changes over a period of time.

PROBLEMS RELATED TO INDEX NUMBERS * Choice of the base period. * Choice of an average. * Choice of index. * Selection of commodities.

* Data collection. CLASSIFICATION OF INDEX NUMBERS * Price Index * Quantity Index * Value Index * Composite Index