A price index shows the average price of a group of goods or services in a certain area during a specified period of time. A price index provides information on price movements over time and variations in prices in different locations. These indexes can help people measure the economy and industries and plan investments.
An economist who wants to calculate this index first chooses a base year, then chooses the group of goods and services whose price movements he or she wants to track. The economist has to gather the prices of these goods and services in the base year and at the present. He or she then calculates a ratio of the prices at the present to the prices in the base year. The simple formula is as follows: (Current prices / Base year prices) X 100. A price index value of above 100 shows an upward movement on prices, while a value of below 100 indicates a downward movement.
For example, consider an economist who only wants to find the price movements of shirts, pants and bread from 2009 to 2010. During the considered period, the price of each shirt has risen from $20 US dollars (USD) to $25 USD, the price of each pair of pants has risen from $10 USD to $12 USD and the price of each loaf of bread has risen from $0.50 to $0.55. If the economist wants the group of goods to consist of 10 shirts, five pairs of pants and 100 loaves of bread, the price of the group of goods is $250 USD — ((10 X $10 USD) + (5 X $20 USD) + (100 X $0.50 USD)) in 2009 and $300 ((10 X $12 USD) + (5 X $25 USD) + (100 X $0.55 USD)) in 2010. The price index can be calculated as follows: ($300 USD / $250 USD) X 100 = 120. The index therefore shows the overall upward movement in prices of goods under consideration.
In reality, teh index often represents a basket of hundreds of goods and services to create a comprehensive depiction of an economy or an industry. There are several types of common price indexes, encompassing an industry or a whole economy. Consumer price index (CPI) covers the retail prices of a large group of goods and services, including food, housing, clothing and transportation, to quantify the cost of living in a particular geographical area. Economists also use the CPI to calculate inflation. Producer price index or wholesale price index measures the prices manufacturers charge for their products, while home price index shows the movements in residential property prices.