Module H5 Session 1

Session 1. Introduction to index numbers

Learning objectives
At the end of this session the students will be able to
Explain what an index number is
Compile a simple index number
Identify diferent types of index numbers
Explain how index numbers can be used in practice
Introduction
This module (H5) presents a number of practical tools and
techniues for producin! the main types of economic statistics" It
follows #odule H$ which pro%ided an o%er%iew of &ey macro'
economic concepts for which statistics are necessary if economic
decision ma&in! is to be soundly based"
Index numbers play a ma(or part in economic statistics) so the
module starts with a number of sessions on some of the main
practical problems in compilin! them" The consumer price index
(C*I) is an important example" The sessions concentrate much more
on the correct way to process the data than on the data collection
aspects) which are relati%ely strai!htforward"
#ost later sessions are de%oted to the +, System of National
Accounts 1993 (-,A) and in particular the estimation of !ross
domestic product (./*)" ./* is perhaps the most widely used
economic indicator) but many statisticians (includin! some top
mana!ers) claim i!norance of the sub(ect" The later sessions aim to
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pro%ide an appreciation of what is in%ol%ed in compilin! the
estimates) especially because) in order to do so) a wide ran!e of
economic data is reuired"
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What is an index number?
In simple terms) an index (or index number) is a number showin! the
le%el of a %ariable relati%e to its le%el (set eual to 033) in a !i%en
base period" 4e be!in by considerin! the simplest form of index
numbers) 5elementary indices6) also &nown as 5relati%es6"
Examples of elementary indices
The population of 7ambia each year may be con%erted into index
numbers with the year 2333 as a base year li&e this"
Year Population
Index
2000=100
2000 9,885,591 100.0
2001 10,089,492 102.1
2002 10,409,441 105.3
2003 10,744,380 108.7
2004 11,089,691 112.2
2005 11,441,461 115.7
2006 11,798,678 119.4
2007 12,160,516
The a%era!e exchan!e rate of Tan8anian shillin!s to +- dollars each
year) con%ert this series into index numbers with the year 2333 as a
base year"
Year TShs per Index
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US$ 2000=100
2000 800.7 100.0
2001 876.4 109.5
2002 966.6 120.7
2003 1038.6 129.7
2004 1089.3 136.0
2005 1128.8

Exercise 1
:ill in the missin! index numbers in the red boxes abo%e" (-ee the
next pa!e if you do not &now how to do the calculations")
;y what percenta!e has the 233< population of 7ambia increased
since the year 2333=
Rule of three
The 5rule of three6 is a %ery useful procedure when deri%in! index
numbers from a series of statistics""
The boxes in the table below form a rectan!le" To calculate the
missin! number) you multiply the numbers in the two boxes ad(acent
to the empty box and di%ide by the number in the box in the
dia!onally opposite corner"
Year TShs per Index
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US$ 2000=100
2000
A
800.7
B
100.0
2001 876.4 109.5
2002 966.6 120.7
2003 1038.6 129.7
2004 1089.3 136.0
2005
C
1128.8
D

/ > ;?C@A > 033?002A"A@A33"< > 0$0"3
,otice that the results can be seen in diferent but mathematically
eui%alent ways" Bne way is thisC the result / (0$0"3) is obtained
by multiplyin! ; (033) by the ratio of C to A (002A"A@A33"< > 0"$03)"
Another way is thisC the result / (0$0"3) is obtained by multiplyin! C
(002A"A) by a Dxed ratio (;@A) 033@A33"< > 3"02$E)"
Types of elementary indices
The examples abo%e are %ery simple (elementary) forms of index
numbers" They refer to a sin!le %ariable) such as the population) the
exchan!e rate or the %alue of somethin! in money terms" These
relati%es do not in%ol%e 5wei!hts6" There are three main types
Falue indices (indicatin! relati%e %alues of anythin! measured
it terms of money)
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Folume or uantity indices (indicatin! relati%e uantities of
somethin!)
*rice indices (indicatin! the relati%e prices of a speciDc item)
iscussion
4hat types of indices the examples !i%en abo%eC %alue) uantity or
price=
Why index numbers?
Indices of the elementary &ind ha%e little %alue in themsel%es" ;ut
they can be used to compile more complex 5composite6 indices)
in%ol%in! many diferent !oods and ser%ices" In economic statistics)
the term 5index numbers6 is usually reser%ed for these more complex
5composite6 indices" Index numbers become essential when
measurin! the chan!e in price of a whole %ariety of products) the
prices of which may be %aryin! in diferent ways"
Bne can always measure the relati%e %alue of a %ariety of thin!s) as
in the turno%er of the manufacturin! industry (for example) in
diferent periods" ;ut a problem arises when you want to separate
out the chan!e in %alue between chan!es in price and chan!es in
uantity" Here is a deDnition of the problemC
The index number problem
The problem is how to combine the relati%e chan!es in the prices
and uantities of %arious products into (i) a sin!le measure of the
relati%e chan!e of the o%erall price le%el and (ii) a sin!le measure of
the relati%e chan!e of the o%erall uantity le%el"
Br) con%ersely) how a %alue ratio pertainin! to two periods of time
can be decomposed in a component that measures the o%erall
chan!e in prices between the two periodsGthat is) the price indexG
and a component that measures the o%erall chan!e in uantities
between the two periodsGthat is) the uantity index"
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There is no uniue way to achie%e this"
-ourceC Producer price index manual: Theory and practice I#:)
4ashin!ton /C) 233$
Types of composite indices
There are only two types of composite indices) (because 5%alue6
indices are always simple relati%es or ratios of %alue)" They are
*rice indices
Iuantity (or %olume) indices
Iuantity and %olume are synonyms here" In economic statistics)
chan!es in uality are to be considered as chan!es in uantity and
included with them"
Althou!h price indices and uantity indices are %ery similar in
theoretical construction) it is %ery important to understand the
diference between them" There is also a fundamental diference
when it comes to measurin! them" Chan!es in the price of an item
are far easier to measure than chan!es in uantity (or %alue)"
The uantities (or %alues) of items sold in diferent outlets may %ary
enormously) dependin! on many factors includin! the si8e and
location of the outlets" *rices) by comparison) will not %ary so much
from outlet to outlet" It is also much easier to Dnd out the price of an
item) than the uantity that may ha%e been sold durin! a month"
Jnowin! price mo%ements in a few outlets will be a !ood !uide to
the a%era!e mo%ement o%erall" There will be a tendency for the
price of similar items to chan!e in a similar way" Bn the other hand)
with some exceptions) uantities may %ary widely and may be
dificult to deDne" Jnowin! uantities (or %alues) from a few outlets
or producers may not be a %ery !ood !uide to the total"
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efinitions
Price (quantity) index
A price (uantity) index is a measure reKectin! the a%era!e of the proportionate
chan!es in the prices (uantities) of the speciDed set of !oods and ser%ices
between two periods of time" +sually the index is assi!ned a %alue of 033 in some
selected base period) and the %alues of the index for other periods are intended to
indicate the a%era!e percenta!e chan!e in prices compared with the base period"
-ourceC I#: **I manual
Base period of a price index
The base period !enerally is understood to be the period with which other periods
are compared and whose %alues pro%ide the wei!hts for a price index" Howe%er)
the concept of the 5base period6 is not a precise one and may be used to mean
rather diferent thin!s" Three types of base periods may be distin!uishedC
(i) the price reference period) that is) the period whose prices appear in the
denominators of the price relati%es used to calculate the index) or
(ii) the weight reference period) that is) the period) usually a year) whose %alues
ser%e as wei!hts for the index" Howe%er) when hybrid expenditure wei!hts are
used in which the uantities of one period are %alued at the prices of some other
period) there is no uniue wei!ht reference period) or
(iii) the index reference period) that is) the period for which the index is set eual
to 033"
The three reference periods may coincide but freuently do not"
-ourceC I#: **I manual
Examples of index numbers
:rom your own &nowled!e) list at least three common price indices
Ana at least one uantity index
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!sing index numbers
Levels and changes
There is often considerable confusion between the level of an index
and changes in the le%els" :or example) the words 5le%el of
inKation6 actually refer to the rate of chan!e in the !eneral le%el of
prices" E%en if inKation is decreasin!) prices will still be !oin! up"
This is li&e sayin! a lorry is slowin! down) but it is still mo%in!
forward"
The index numbers can tell you the percenta!e chan!e that has
occurred between any two periods"
Exercise "
Calculate the annual rates of chan!e of the population of 7ambia and
those of the Tan8anian exchan!e rate" 4hat can you say about the
rates of chan!e in each case=
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#o$ is the consumer price index used?
This is an extract from the ILBMs consumer price index manual
The origins and uses of consumer price indices
C*Is must ser%e a purpose" The precise way in which they are deDned and
constructed depends on what they are meant to be used for) and by whom"
C*Is ha%e a lon! history datin! bac& to the ei!hteenth century" Laspeyres
and *aasche indices) which are still widely used today) were Drst proposed
in the 0A<3s" The concept of the cost of li%in! index was introduced early
in the twentieth century"
Traditionally) one of the main reasons for compilin! a C*I was to
compensate wa!e'earners for inKation by ad(ustin! their wa!e rates in
proportion to the percenta!e chan!e in the C*I) a procedure &nown as
indexation" :or this reason) oficial C*Is tended to become the
responsibility of ministries of labour) but most are now compiled by
national statistical ofices" A C*I that is speciDcally intended to be used to
index wa!es is &nown as a compensation index"
C*Is ha%e three important characteristics" They are published freuently)
usually e%ery month but sometimes e%ery uarter" They are a%ailable
uic&ly) usually about two wee&s after the end of the month or uarter"
They are also usually not re%ised" C*Is tend to be closely monitored and
attract a lot of publicity"
As C*Is pro%ide timely information about the rate of inKation) they ha%e
also come to be used for a wide %ariety of purposes in addition to indexin!
wa!es" :or exampleC
C*Is are widely used to index pensions and social security beneDts"
C*Is are also used to index other payments) such as interest
payments or rents) or the prices of bonds"
C*Is are also commonly used as a proxy for the !eneral rate of
inKation) e%en thou!h they measure only consumer inKation" They
are used by some !o%ernments or central ban&s to set inKation
tar!ets for purposes of monetary policy"
The price relati%es deri%ed for C*I purposes can also be used to
deKate household consumption expenditures or other items in
national accounts"
These %aried uses can create conKicts of interest" :or example) usin! a C*I
as an indicator of !eneral inKation may create pressure to extend its
co%era!e to include elements that are not !oods and ser%ices consumed by
households) thereby chan!in! the nature and concept of the C*I" It should
also be noted that because of the widespread use of C*Is to index a wide
%ariety of payments 1 not (ust wa!es) but social security beneDts) interest
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payments) pri%ate contracts) etc" 1 extremely lar!e sums of money may turn
on their mo%ements) enou!h to ha%e a si!niDcant impact on the state of
!o%ernment Dnances" Thus) small diferences in the mo%ements of C*Is
resultin! from the use of sli!htly diferent formulae or methods can ha%e
considerable Dnancial implications" C*I methodolo!y is important in
practice and not (ust in theory"
-ourceC onsumer price index manual: Theory and practice !hapter 1"
ILB) .ene%a) 233$)
Exercise %
Two uses of price indices are !i%en below) indexation and deKation"
Indexation
Consider a buildin! contract in which it is a!reed that monthly
payments will be indexed accordin! to a !i%en price index" -uppose
the %alue of the wor& done in /ecember (accordin! to the ori!inal
prices) was A3)333 *ula" -uppose the price index for /ecember was
0<2 while the price index was ori!inally 0H3 at the time the contract
price was a!reed" 4hat would the indexed payment be=
4rite down your calculations in detail
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eflation
The followin! data come from -outh Africa" :irst) construct a %alue
index of ban& deposits based on the year 2333" Then use the C*I to
obtain an index of the 5real6 %alue of ban& deposits" (/i%ide the %alue
index by the price index) and multiply by 033")
Bank deposits Value index CPI !uni"
#ipalities$
Index o% &eal
'ank deposits
(ea& )and *illions 2000+100 2000+100 2000+100
1999 550,158 94.9
2000 602,617 100.0
2001 719,887 105.7
2002 812,290 115.4
2003 911,284 122.1
2004 1,033,134 123.8
2005 1,232,628 128.0
2006 1,539,452 134.0
4hat &ind of an index is the last column 1 %alue) uantity or price=
4hat was the a%era!e annual rate of !rowth in the real %alue of ban&
deposits between 2333 and 2335=
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