Using Index Numbers (AQA A Level Economics)

• An index number is a tool economists use to track changes in prices, quantities, or economic activity over time
  • Index numbers are a way of standardising economic data so as to make easier comparisons between countries
    

How to create an index

Step 1: Select the items

• Determine what items or variables you want to measure such as prices or other economic indicators

Step 2: Select the base period

• Choose a base period against which all future observations will be compared
• This period typically serves as the reference point with an index value of 100

Step 3: Data collection

• Gather data for the selected items or variables over time, including during the base period

Step 4: Weighting (if applicable)

• Assign weights to each item based on their relative importance
• This step is common when constructing composite indices like the Consumer Price Index (CPI)

Step 5: Index calculation

• Multiply each item's value by its weight (if applicable) and sum them up to obtain the index value for the current period

Step 6: Interpretation

• Analyse the index values to understand trends or changes in the measured variables over time

• Inflation is the sustained increase in the general price level in an economy
   
• The UK uses two inflation indices and each is calculated slightly differently
  • The consumer price index (CPI)
  • The retail price index (RPI)

Consumer Price Index (CPI) 

• The Consumer Price Index (CPI) measures changes in the average level of prices paid by households for goods and services during a specific time period
   

The Construction of the CPI

Steps	Explanation
Step 1: Selection of goods and services	A selection of 700 goods and services are selected as a typical ‘household basket’ each month.  This is determined through household expenditure survey Each year, some goods and services exit the basket and new ones are added
Step 2: Collection of price data	Usually, on a monthly basis, prices for each item in the basket are collected from a 150 locations across the country  The number of goods in the basket varies from country to country, e.g. the UK has 700 'goods' in their basket and Singapore has 4,800
Step 3: Weighting	Goods and services in the basket are weighted based on the proportion of household spending E.g. More money is spent on food than shoes, so shoes have a lower weight in the basket The price x weighting determines the final value of the good or service in the basket

Using the CPI to calculate inflation

• The formula used to calculate the CPI is

• Once the index number has been calculated, the percentage difference between two index numbers represents the rate of inflation

The Retail Prices Index (RPI) 

• The retail price index (RPI) is calculated in exactly the same way as the CPI
  • Certain goods and services that are excluded from the CPI are included with the RPI
    • These include council tax, mortgage interest payments, house depreciation, and other house purchasing costs such as estate agents fees
      
      
• Due to the extra inclusions, inflation measured using the RPI is usually higher than the CPI
  • This is mainly due to its sensitivity to interest rate changes, which affect mortgage interest
  • It is argued that the RPI is a more accurate indication of a households inflation