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A price index is any single number calculated from an array of prices and quantities over a period. Since not all prices and quantities of purchases can be recorded, a representative sample is used instead. Inflation and cost indices are calculated as price indices. Notable price indices are The GDP deflator differs from the consumer and producer price indexes in that it does not assume a fixed market basket of goods and services.
Calculating price indices There are two main methods to calculate price indices, the Paasche index (after the German economist Hermann Paasche) and the Laspeyres index (after the German economist Etienne Laspeyres). The Paasche index is P_P = rac, while the Laspeyres index computes as P_L = rac, where is the change in price level, and are the prices and quantities in the base year (usually the first), and those in the year t. A Laspeyres index of 1 states that an agent in the current period can afford to buy the same bundle as he consumed in the previous period, given that income has not changed. A Paasche index of 1 states that an agent could have consumed the same bundle in the base period as she is consuming in the current period, given that income has not changed. The Laspeyres index systematically overstates inflation, while the Paasche index understates it, because the indices do not account for the fact that consumers react to price changes by changing the quantities they buy. A third index, the Fisher index (after the American economist Irving Fisher), tries to get around this problem. It is calculated as the geometric mean of and : P_F = sqrt. See also | ||||||||
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