Question

Why do economists use index numbers to measure the price level rather than dollar value of goods?

Short answer

Economists use index numbers to measure the price level rather than the dollar value of goods because index numbers offer comparative simplicity, accurate inflation tracking, differentiation between changes in quantity and price, and the ability to convert values to constant dollars. This allows for better analysis and understanding of economic growth and the impact of economic policies. Using dollar values can lead to misleading results due to inflation, deflation, lack of comparability, and difficulty in measuring the impact of economic policies.

Step-by-step solution

Introduction to Index Numbers

Index numbers are a statistical tool used by economists to measure the changes in a specific economic variable over time. They provide a simple way of comparing changes in price, quantity, or value from a base period.

The Base Period and the Index Number Formula

The base period is a specific point in time chosen as a reference for calculations. The value of the index number in the base period is usually set to 100. The index number formula is given by: \(Index\, Number\, (IN) = \frac{Value\, in\, Comparison\, Period}{Value\, in\, Base\, Period} \times 100\)

Calculating the Index Number for Price Level

Economists often use the Consumer Price Index (CPI) to measure the price level. It is the ratio of the value of a basket of goods and services in a specific year to the value of the same basket in the base year, multiplied by 100. In other words, the CPI measures the percentage change in the cost of living compared to a base year.

Advantages of Using Index Numbers

Now let's look at the advantages of using index numbers to measure the price level: 1. Comparative simplicity: Index numbers are easy to understand and provide a single number that shows the magnitude of change from the base period. 2. Inflation tracking: Index numbers such as the CPI help economists to track inflation accurately and help policymakers to make informed decisions. 3. Differentiate between changes in quantity and price: Dollar values of goods alone do not differentiate between an increase in price and an increase in the quantity of goods. Index numbers can help separate these changes. 4. Constant dollar values: Index numbers can be used to convert values of goods to constant dollars, which helps to analyze the growth of an economy by taking inflation or deflation into account.

Problems with Using Dollar Values

Using the dollar value of goods has several drawbacks, which make index numbers a more appropriate tool for measuring the price level: 1. Inflation or deflation: The dollar value of goods can change due to inflation or deflation, which would give misleading results for comparing the price level over different periods. 2. Lack of comparability: Dollar values make it difficult to compare the price levels of different commodities in different periods. 3. Difficulty in measuring the impact of economic policies: Changes in dollar values alone make it difficult to evaluate the impact of economic policies on the price level. In summary, index numbers provide a more accurate and straightforward way of measuring and comparing the price level over time, which is why economists prefer them over using the dollar value of goods.