Q. What do you mean by Price index?
Because we are only interested in percentage change of the price level and not particular value, we can divide every price level by a given constant so that numbers are easier to deal with.
When we divide a series of price levels by a constant we end up with what is known as a time series of price indexes.
Using same basket as above, if we divide entire series by 607.70 we get following time series of price indexes:
|
Point in time
|
Jan 1, 2008
|
Feb 1, 2008
|
March 1, 2008
|
April 1, 2008
|
|
Price index
|
100
|
102.68
|
103.42
|
103.42
|
Reason for choosing 607.70 is that we want the index to be equal to 100 for the first point in time. Benefit of having an index which starts with 100 is that we would have a clearer picture of evolution of prices. We can, for instance, immediately determine that prices rose by 2.68% on average in January and by 3.42% during three months January to March.
Note that percentage change of the original price level and percentage change of price index is the same. Percentage change won't depend on which point in time we select as our 'base' (giving the price index a value of 100). Using price index, percentage change during January is (62400 - 60770)/60770 = 2, 68% that is exactly the same as percentage change of the price index.