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A LevelEconomicsAQARevision NotesThe National & International Economy9. Measuring Macroeconomic PerformanceUsing Index Numbers

Using Index Numbers (AQA A Level Economics)

Revision Note

Lorraine

Written by: Lorraine

Reviewed by: Steve Vorster

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

Worked Example

An economy's GDP increased from $500 billion in 2017 to $540 billion in 2019. Using 2016 as the base year, establish the value of the index for GDP in 2018 and comment on its significance

Step 1: Calculate the Index for 2019 using the formula

Index space for space 2019 space equals space fraction numerator Real space GDP space 2019 over denominator Real space GDP space base space year end fraction space straight x space 100 Index space for space 2019 space equals space fraction numerator $ 540 space billion over denominator $ 500 space billion end fraction space straight x space 100 Index space for space 2019 space equals space 108 [1 Mark]

 Step 2: Comment on the value

         The value of the GDP has increased by 8 percent in this period   

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


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

CPI space equals space fraction numerator Cost space of space basket space in space current space year over denominator Cost space of space basket space in space base space year end fraction cross times 100

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

Inflation space rate space equals space fraction numerator New space CPI space minus space Previous space CPI over denominator Previous space CPI end fraction space straight x space 100

Worked Example

  • Using the information in the table, calculate the inflation rate for 2021, if the price of the basket in the base year (2019) was $400  [3]


Household Item


Price 2020


Price 2021


Basket Weight


Cost of Basket in 2020

(Price xWeight) 


Cost of Basket in 2021

(Price xWeight) 

Housing, water, electricity, gas

950

1200

34%

323.00

408.00

Transport 

250

325

11%

27.50

35.75

Food

500

620

9%

45.00

55.80

Recreation & culture

300

340

10%

30.00

34.00

Clothing & footwear

190

210

5%

9.50

10.50

 

 

 

 

$435.00

$544.05

 Step 1: Calculate the CPI for 2020

CPI space equals space fraction numerator Cost space of space basket space 2020 over denominator Cost space of space basket space in space base space year end fraction cross times 100 CPI space equals space fraction numerator space 435 over denominator 400 end fraction cross times 100 CPI space equals space 108.75

Step 2: Calculate the CPI for 2021

CPI space equals space fraction numerator Cost space of space basket space 2021 over denominator Cost space of space basket space in space base space year end fraction cross times 100 CPI space equals space fraction numerator space 544.05 over denominator 400 end fraction cross times 100 CPI space equals space 136.01
 

Step 3: Calculate the CPI for 2020

 Inflation space rate space equals space fraction numerator New space CPI space minus space Old space CPI over denominator Old space CPI space end fraction cross times 100 Inflation space rate space equals space fraction numerator 136.01 space minus space 108.75 over denominator 108.75 end fraction cross times 100 Inflation space rate space equals space 25.07 percent sign               

3 marks for the correct answer or 1 mark for any correct working. The final answer should be rounded to 2 decimal places

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

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    Author
    Reviewer
    Lorraine

    Author: Lorraine

    Expertise: Economics Content Creator

    Lorraine brings over 12 years of dedicated teaching experience to the realm of Leaving Cert and IBDP Economics. Having served as the Head of Department in both Dublin and Milan, Lorraine has demonstrated exceptional leadership skills and a commitment to academic excellence. Lorraine has extended her expertise to private tuition, positively impacting students across Ireland. Lorraine stands out for her innovative teaching methods, often incorporating graphic organisers and technology to create dynamic and engaging classroom environments.

    Steve Vorster

    Author: Steve Vorster

    Expertise: Economics & Business Subject Lead

    Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.