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101 Concepts for the Level I Exam

Concept 28: Inflation Measures


Laspeyres index is the most common type of index; which uses a constant basket of goods and services. The three factors that cause the index to biased upwards are:

  • New goods: Older goods are replaced by newer goods that are initially more expensive.
  • Quality changes: Quality improvements can cause the increase in basket price without any inflation.
  • Substitution: Consumers prefer substitute products.

Paasche index uses the current weights of basket to derive the base year basket price while determining the rate of change.  It is used to address the issue arising from substitution.

Fischer index is a geometric mean of Laspeyres and Paasche index.

Compute the Paasche index for the following simple basket of goods:

Item Base period quantity Base period price Current period quantity Current price
Apparel 100 25.00 105 30.00
Burgers 50 3.50 40 4.50
Gasoline 80 2.00 95 3.50
Books 65 4.00 50 3.00

Solution:

Base period:
Apparel=105*25=2,625
Burgers=40*3.5=140
Gasoline=95*2=190
Books=50*4=200
Cost of basket=3,155
Current period:
Apparel=105*30=3,150
Burgers=40*4.5=180
Gasoline=95*3.5=332.5
Books=50*3=150
Cost of basket=3,812.5
Paasche index={{3,812.5}\over {3,155}}*100=121