What methods of Index Number calculation is used to calculate Cost of Living

Index (CLI).
Prepared by : Souik Dey , Roll no : FT 153079

Before dive into the topic, let us first discuss the facts about index number.

Index No: Index numbers are quantitative measures of growth of prices, production, inventory and
other quantities of economic interest. We calculate the index no by finding the ratio of the current
value to a base value.
Cost of living index numbers generally represent the average fluctuations in the commodity price
level over a period of time, paid by a consumer for fixed set of goods and services. It measure the
relative changes over the time in the cost level require to maintain similar standard of living.

Now Cost and living price index covers the prices of below item categories:
1. Food. 2 Clothing. 3 Fuel and lighting .4 Housing and miscellaneous.

Uses of cost of living index numbers:
1. Cost of living index numbers indicate whether the real wages are rising or falling. In other
words they are used for calculating the real wages and to determine the change in the
purchasing power of money.
Purchasing power of money= ( 1/ cost of living index number).
Real Wages= (Money wages / cost of living index numbers) x 100.
2. Cost of living indices are used for the regulation of D.A or the grant of bonus to the workers
so as to enable them to meet the increased cost of living.
3. Cost of living index numbers are used widely in wage negotiations, regulation of DA or grant
of bonuses to the workers.

Methods for construction of cost of living index numbers:
1. Aggregate expenditure method or weighted aggregative method
2. Family budget method or the method of weighted relatives

1. Aggregate expenditure method or weighted aggregative method
In this method the quantities of commodities consumed by the particular group in the base year
are taken as weights. There are majorly 3 methods namely 1. Laspereys method.2. Paasches
method. 3. Fishers ideal method.
i. Laspereys method:. In this method the base year quantities are taken weights. The formula for
constructing Laspereys price index number is
P
01
La
=
100
0 0
0 1

q p
q p

ii. Paasches method: In this method the current year quantities are taken as weights and the formula
is given by
P
01
Pa
=

iii. Fishers ideal method: Fishers price index number is given by the G.M of the Laspereys and
Paasches index numbers.
P
01
F
=

100
1 0
1 1

q p
q p
Pa La
P P
01 01
P
0
are the base year prices.
P
1
are the current year prices
P
01
is the price index number for the current year with reference to the base year.
Q
1
are the current year quantities.
Q
0
are the base year quantities.

Out of above mentioned 3 methods, fisher method is considered to be the best method to calculate
the subject index number for the following reasons:
It is based on the G.M which is theoretically considered as the best average of constructing
index numbers.
It takes into account both current and base year prices as quantities.
It satisfies both time reversal and factor reversal test which are suggested by Fisher.
It is free from bias as it considers both current and base year price and quantity.

2) Family budget method or the method of weighted relatives:

In this method cost of living index is obtained on taking the weighted average of price relatives,
the weights are the values of quantities consumed in the base year i.e.
Thus the consumer price index number is given by

,
0 0
q p v
Cost of living index numbers = Where for each item

Value on the base year.


Even though both the weighted aggregative method and the method of weighted relatives should
yield the same result, but it is preferable to opt for the later one (mainly fisher method) due to its
simple approach to apply.

However, Cost of living index numbers or its recently popular name consumer price index numbers
are not accurate due to the reasons herein below:
Errors may occur in the construction because of inaccurate specification of groups for whom
the index is meant.
Faulty selection of representative commodities resulting out of unscientific family budget
enquiries.
Inadequate and unrepresentative nature of price quotations and use of inaccurate weights
Frequent changes in demand and prices of the commodity
The average family might not be always a representative one.

v
pv 100
1

o
p
p
p
0 0
q p v