Principles of Macroeconomics / Unit 6 MAC 0505 worked example, 60 to 90 seconds
Building a Price Index
The idea
Four steps build an index. First choose the basket: which goods, and how much of each a typical buyer buys. Second, price that basket in the base period and total the cost. Third, price the same basket, with the same quantities, in the current period and total it. Fourth, divide the current cost by the base cost and multiply by one hundred. The quantities stay fixed between steps two and three, so any change in the total comes from prices alone.
In practice
Worked example: a basket of four books and three meals. In the base year books cost ten dollars and meals twenty, so the basket costs forty plus sixty, a hundred dollars. In the current year books cost twelve and meals twenty-five, so the basket costs forty-eight plus seventy-five, a hundred and twenty-three. The index is a hundred and twenty-three over a hundred, times a hundred, which is a hundred and twenty-three.
Where people slip
Use the same quantities in both years. Repricing with the current year's quantities measures something else, and mixing the two is the commonest way these calculations go wrong.
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