Using Index Numbers (AQA A Level Economics): Revision Note

An Introduction to Index Numbers

• 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

Calculating Inflation

• 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

Using the CPI to calculate inflation

• The formula used to calculate the CPI is

$\mathrm{CPI}=\frac{\mathrm{Cost}\mathrm{of}\mathrm{basket}\mathrm{in}\mathrm{current}\mathrm{year}}{\mathrm{Cost}\mathrm{of}\mathrm{basket}\mathrm{in}\mathrm{base}\mathrm{year}}\times 100$

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

$\mathrm{Inflation}\mathrm{rate}=\frac{\mathrm{New}\mathrm{CPI}-\mathrm{Previous}\mathrm{CPI}}{\mathrm{Previous}\mathrm{CPI}}\mathrm{x}100$

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