A price index (plural: price indices or price indexes) is a normalized average (typically

a weighted average) of pricerelatives for a given class of goods or services in a given region, during
a given interval of time. It is a statistic designed to help to compare how these price relatives, taken
as a whole, differ between time periods or geographical locations.
Price indexes have several potential uses. For particularly broad indices, the index can be said to
measure the economy's general price level or a cost of living. More narrow price indices can help
producers with business plans and pricing. Sometimes, they can be useful in helping to guide
investment.

A consumer price index (CPI) measures changes in the price level of a market basket of consumer
goods and services purchased by households.
The CPI is a statistical estimate constructed using the prices of a sample of representative items
whose prices are collected periodically. Sub-indices and sub-sub-indices are computed for different
categories and sub-categories of goods and services, being combined to produce the overall index
with weights reflecting their shares in the total of theconsumer expenditures covered by the index. It
is one of several price indices calculated by most national statistical agencies. The annual
percentage change in a CPI is used as a measure of inflation. A CPI can be used to index (i.e.,
adjust for the effect of inflation) the real value of wages, salaries, pensions, for regulating prices and
for deflating monetary magnitudes to show changes in real values. In most countries, the CPI is,
along with the population census one of the most closely watched national economic statistics.

A Producer Price Index (PPI) measures the average changes in prices received by domestic
producers for their output. It is one of several price indices.
Its importance is being undermined by the steady decline in manufactured goods as a share of
spending

Price Index
Since Inflation is broadly defined as an increase in the general price level, in order to accurately measure inflation we
must first assess the general price level. The general price level is measured by a price index. A price index is a
weighted average of the prices of a selected basket of goods and services relative to their prices in some base-year.

To construct a price index we start by selecting a base year. Then we take a representative sample of goods and
services and calculate their value in the base year and current prices. The ratio of the expenditures on the basket of
goods at current prices to the expenditure at the base year prices is taken as the price index.
For example, suppose our basket of goods consists of only three items: shirts, pants and bread with the following
prices and quantities in 2006 and 2007:
Item

Quantity

Price in 2006

Price in 2007

Exp. in 2006

Exp. in 2007

Shirts

10

$10

$12

$100

$120

Pants

$20

$25

$100

$125

Bread

100

$0.50

$0.55

$50

$55

$250

$300

TOTAL

We're now going to calculate the Market Basket values for 2006 and 2007. Values that indicateQuantity will be
in bold.
Market Basket for 2006 = (10* $10) + (5* $20) + (100* $0.50) = $100 + $100 +$50 = $250
Market Basket for 2007 = (10* $12) + (5* $25) + (100* $0.55) = $120 + $125 + $55 = $300
Notice that the same quantities were used for both calculations. Undoubtedly the quantities of good would change
year to year, however we want to hold these quantities constant so we can see the impact of the price changes.
To calculate the Price Index, take the price of the Market Basket of the year of interest and divide by the price of the
Market Basket of the base year, then multiply by 100. In this case we're interested in knowing the price index for
2007 and we plan to use 2006 as the base year.

Price Index for 2007= Market Basket for 2007 * 100 = 300 * 100 = 120
Market Basket for 2006
250
Note that the Price Index for the base year will allways be 100. This is because you will be dividing the Market
Basket in the base year by itself (which will give you a value of 1) and multiplying by 100 (which will then give you a
value of 100).
Thus the Price Index for 2006 = Market Basket for 2006 * 100 = 250 * 100 = 100
Market Basket for 2006

250

Producer Price Index (PPI) is a price index that represents the changes in the selling prices received by the
producers. PPI measures inflation from producer's perspective.
PPI for any period is likely to be different from the CPI because producers sell not only consumer goods but also
intermediate goods to other firms at different stage. Even for final goods, the price received by the producers is often
different from the price paid by the buyers because the latter includes taxes, subsidies, and distribution costs.

There are actually three different producer price indexes for goods representing the various stages of production: raw
materials, intermediate goods, and finished goods. These various indexes are important because if the cost of goods
at an early stage of production go up it can be an early predictor of future inflation since when the costs of inputs
goes up, firms often raise their prices. This is an example of Cost Push Inflation.

Cost-Push Inflation - There are also supply-side factors that may trigger inflation. For example, if prices of some key
inputs like oil rise, producers will have to either adjust output supply or translate the higher costs into higher output
prices. When output declines because of cost pressure on producers there will be a shortage in output markets and
prices will rise as a result, ceteris paribus, meaning all else constant. This is called cost-push inflation. Prices may
also rise as a result of uncertainty about future market conditions.
Consumer Price Index (CPI) is a weighted average of the prices of a fixed basket of consumer goods where the
weights are assigned on the basis of the share of each good in the average consumer's expenditure. Unlike the GDP
deflator whose basket of goods changes every year, CPI is based on the same basket of goods from year to year.
The categories of consumer goods and their respective weights used in the construction of CPI in USA are given
below.

Good/Service

Percentage Share in Average Consumer's Budget

Housing

42.1%

Transportation

16.9%

Food and Beverage

15.4%

Medical Care

6.1%

Education and Communication

5.9%

Recreation

5.9%

Clothing

4.0%

Others

3.7%

The CPI is considered an index that best reflects the impact of changes in prices on consumer welfare. But some
argue that CPI is biased towards the base year since it keeps the consumption patterns that prevailed in the base
year fixed for subsequent years and hence may not fully reflect the impact of changes in prices on consumer welfare.
For example, when relative prices change consumers will be substituting a cheaper good for the good whose relative
price has gone up. As a result, the actual consumer expenditure at any time might be less than what is used in the
construction of the CPI on the basis of the weights that prevailed in the base year. As a result the CPI may
exaggerate inflation and overstate the loss in consumer welfare due to inflation. In addition, the CPI does not reflect
what is happening to the prices of new goods introduced after the base year. The CPI also fails to make a distinction
between a rise in prices resulting from quality improvements and that from inflationary pressure. A more frequent
revision of the basket of goods may help address these limitations.
Essentially, GDP Deflator is an adjustment for the impact of changes in prices on changes in nominal GDP. GDP
Deflator can be considered the most comprehensive measure of inflation since a wide array of goods and services

are included in its construction. But it may not reflect the full impact of inflation on consumer welfare because it does
not include imported goods and services that constitute a significant portion of what people buy.
GDP Deflator is the ratio of the value of aggregate final output at current market prices (Nominal GDP) to its value at
the base year prices (Real GDP). In effect the basket of goods for the construction of this price index includes all the
final output produced within the geographic boundaries of the country.
GDP Deflator = Nominal GDP/ Real GDP
Nominal GDP:
Nominal GDP can change from time to time because of two reasons:

changes in the physical volume of output or

changes in the prices at which output is valued

We want to use GDP to look at changes in the physical volume of output. Since Nominal GDP can also change due
to changes in the prices at which output is valued it is necessary to "deflate" the value recorded for Nominal GDP
(GDP with inflation) into "real" dollars so we can make comparisons across years.
Real GDP:
When we divide GDP at current market prices (Nominal GDP) by the corresponding GDP deflator, we obtain what is
called real GDP.
Real GDP = Nominal GDP / GDP Deflator
Real GDP can change only because of changes in the physical volume of output. As a result Real GDP is considered
a better measure of economic growth than nominal GDP.
Adjustments to GDP with GDP Deflator
Since inflation changes from year to year, and a nations productivity level over time is tracked in monetary terms
using GDP, how can you tell if a change in a country's level of output is due to a real change in productivity or
whether it is due to fluctuations in the level of the prices of that output? The answer is you can't.
If you recall the concept of "holding all else constant" you will quickly realize that without adjusting GDP to account for
the effect of inflation, you will be unable to accurately compare a country's GDP from year to year.
To deal with this issue, a "fudge factor" called the GDP deflator is used to convert Nominal GDP (GDP with the effects
of inflation) into Real GDP (GDP without the effects of inflation). Nominal GDP is divided by the GDP deflator to get
Real GDP. Basically, the GDP deflator is used to "cancel out" the effects of inflation.
Inflation is calculated by taking the price index from the year in interest and subtracting the base year from it, then
dividing by the base year. This is then multiplied by 100 to give the percent change in inflation.

Inflation = (Price Index in Current Year Price Index in Base Year) * 100

Price Index in Base Year

From our previous example:

Inflation = (120-100) * 100 = 0.2 * 100 = 20%
100

Thus from 2006 to 2007, inflation has risen 20%.

In this context, inflation is measured as a percentage change in the price index from one period to the next.
If the percentage change in the price index is negative it shows deflation rather than inflation.

SOURCE: http://www.econport.org/content/handbook/Inflation/Price-Index/CalcwPI.html