Price index is a measure of the normalized average prices of a basket of goods and services. It tracks the trend in prices over a given period.
We use the index to measure inflation. The percentage change in the index from one period to another represents the inflation rate.
Many different measures of inflation based on different price indices. Some notable price indices are wholesale price index, producer price index, consumer price index, and GDP deflator.
Types of price index calculations
Three types of methods in building an index, including:
- Laspeyres index uses a constant basket of goods and services
- Paasche Price Index uses the current composition of a basket of products and services
- Fisher index equals the geometric mean of the Paasche Price Index and the Laspeyres Price Index.
The Fisher Index is more ideal because it overcomes the calculation bias in the other two indices by calculating the average of both. When prices rise, consumers might replace expensive items with cheaper substitutes. As a result, the current quantity is lower than in the base year. The Laspeyres index overestimates the price index because it uses the same quantity of goods in the base year. Conversely, because it uses the current quantity, the Paasche index number will tend to underestimate.