Uses of a price index

In practice there are two broad categories that the price indices published by national statistical agencies fall into: consumer price indices (CPIs) and producer price indices (PPIs). As the names suggest, CPIs are focused on measuring price changes for goods and services that are purchased by consumers (final consumption), whereas PPIs focus on measuring prices charged by producers for goods and services produced, and prices paid for inputs into production. Despite the many subtleties about what constitutes a consumer and what constitutes a producer, both CPIs and PPIs seek to measure the change in prices over time for the goods and services that are transacted in an economy. Consequently, there is often considerable overlap in how CPIs and PPIs are calculated and used, and a distinction does not need to be made between whether an index is a CPI or a PPI—it often suffices to talk about a general price index.

Probably the most important use of a price index, be it a CPI or a PPI, is to measure inflation—the systematic change in prices in an economy over time. Beyond being an important macroeconomic indicator, the measure of inflation directly affects many economic interactions in modern economies. For instance, many central banks operate in a regime of inflation targeting, whereby monetary policy is conducted in part to keep the inflation rate in a predetermined range (e.g., 1% to 3% a year). This policy regime requires a frequent and timely measure of inflation, and the instrument used to measure inflation can have a direct impact on monetary policy, and consequently interest rates. Inflation also affects wages and service contracts, pension payments, and social security benefits, as these contracts are often indexed to inflation—if prices increase by 2% per year, then wages also increase by 2% per year. Indexation preserves the value of payments over time without constantly needing to renegotiate contracts or redesign policies. The measure of inflation thus has important implications for household income and industry revenues.

Beyond measuring inflation, one of the major uses of price indices for national statistical agencies is to deflate aggregate values in a national accounting framework to get a measure of the change in the production of real goods and services over time. This is equivalent to finding a quantity index to systematically condense information about many outputs for a range of goods and services into a single value that measures the change in the quantity of goods and services produced over time. Although there are many details, the rationale behind deflating aggregate values to get a measure of real output is fairly simple. If \(V_1/V_0\) is the ratio of the value of production in period 1 to the value of production in period 0, and if this can be decomposed into a quantity index \(Q\) and a price index \(I\) such that \(V_1/V_0 = IQ\), then the change in real production between period 0 and period 1 is simply \(Q = V_1 / (V_0 I)\). The change in the value of production over time—a known quantity—can be turned into a measure of the change in real output by simply deflating it with a price index.