Uses and Limitation of Inflation Measures

There are two major measures of inflation: the consumer price index and the producer price index.

Consumer Price Index (CPI)

The consumer price index is an inflationary measure that considers using a consumption basket as a tool or an indicator for analysis. A number of consumer price indices have been created over the years. Here are some examples:

Laspeyres Price Index

The Laspeyres price index is the most widely used measure. It involves the usage of a fixed basket of goods and services. However, this has created limitations for the Laspeyres price index.  Below are highlights on each of these limits.

1. New Product Bias

This circumstance results in upward biases in the inflation rate. Also, introducing new products results in the exclusion of some other components from the fixed baskets of goods. An example of this could be tablets or smartphones.

2. Quality Bias

When the quality of products in the market ameliorates from time to time, people’s needs are satisfied, and the demand for the products increases. Therefore, the quality of the products must be adjusted. Otherwise, the measured inflation incurs another upward bias.

3. Substitution Bias

When the prices of certain goods and services go up, buyers tend to opt for substitutes whose prices are lower. This substitution may lead to an upward bias.

Paasche Price Index

The Paasche price index was developed by German economist Hermann Paasche. This index measures the change in the price and quantity of a basket of goods and services relative to base year price and observation year quantity.

Fisher Price Index

This price index was developed by American economist Irving Fisher to correct substitution bias problems created by the Laspeyres index. It is defined as the geometric average of the Laspeyres price index (which only uses the base period basket) and the Paasche price index.

Producer Price Index (PPI)

The producer price index is also a significant inflation measure. The producer price index mirrors price transformations experienced by domestic producers in a country. This is because when prices go up, they may ultimately pass through the consumers. Items that fall under the PPI are products that undergo the stage of processing ranging from raw materials, intermediate materials to finished materials.

Compared with the consumer price index, the producer price index is difficult to compute since it involves assigning the correct weights to each item. This can also be explained by the fact that different countries specialize in different industries.

Question

The Fisher Price Index is created by using the:

A. geometric average of the Laspeyres and Paasche price indices;

B. arithmetic average of the Laspeyres and Paasche price indices; or

C. harmonic average of the Laspeyres and Paasche price indices.

Solution

The correct answer is A.

The change in a Fisher index from one period to the next is the geometric mean of the changes in Laspeyres’s and Paasche’s indices between those periods.