Meaning and Uses of Index Numbers

An index number is a statistical measure that expresses the average relative change in a variable (or a group of related variables, like the prices of a basket of goods) between one period — the base period — and another — the current period. The base period is always given the value $100$, and every other period's index is read as a percentage relative to that base.

For a single commodity, this is simply a price relative:

where $p_0$ is the base-year price and $p_1$ is the current-year price. An index number generalises this idea to a whole basket of commodities at once — for example, a Wholesale Price Index or Consumer Price Index combines the price movements of dozens of items into a single representative figure.

Uses of index numbers in business and government:

1. Measuring the general price level and, from it, the rate of inflation or deflation in the economy.
2. Adjusting wages, pensions and contracts ('dearness allowance') so that real purchasing power keeps pace with rising prices.
3. Deflating other economic series — converting a value figure (like national income at current prices) into a real figure at constant prices, by dividing through by a suitable price index.
4. Guiding business and government policy — a rising index of industrial production signals expansion; a rising price index signals the need for anti-inflationary measures.
5. Forecasting — index numbers, plotted over time, are themselves a time series and can be studied for trend exactly as in the previous sections of this chapter. …