Uses of index numbers, Financial Management

Uses of Index Numbers

1. Establishes trends

Index numbers when analyzed reveal a general trend of the phenomenon under study. The available figures for inflation based on wholesale price index and consumer price index suggest that in 1993, inflation is lower than that in the earlier three years and was the highest in 1991 and started declining subsequently. Refer the table on the next page.

2. Helps in policy making

It is widely known that the dearness allowance paid to the employees is linked to the cost of living index, generally the consumer price index. From time to time it is the cost of living index which forms the basis of many a wage agreement between the employees union and the employer. Thus index numbers guide policy making.

3. Determines purchasing power of the rupee

Usually index numbers are used to determine the purchasing power of the rupee. Suppose the consumer price index for urban non-manual employees increased from 100 in 1984 to 202 in 1992, the real purchasing power of the rupee can be found out as follows:

100/202

= 0.495

It indicates that if rupee was worth 100 paise in 1984 its purchasing power is 49.5 paise in 1992.

4. Deflates time series data

Index numbers play a vital role in adjusting the original data to reflect reality. For example, nominal income (income at current prices) can be transformed into real income (reflecting the actual purchasing power) by using income deflators. Similarly, assume that industrial production is represented in value terms as a product of volume of production and price. If the subsequent year's industrial production were to be higher by 20% in value, the increase may not be as a result of increase in the volume of production as one would have it but because of increase in the price. The inflation which has caused the increase in the series can be eliminated by the usage of an appropriate price index and thus making the series real.

Construction of Real Wage Indices

Year

     Nominal wages 

      (Rs.)

Consumer price index

Real   
 wages (Rs.)

Real wage index
 (base 1985 = 100)

 

 

       (a)

 

(b)

(c = (a/b) * 100 )

 

(d = (c/a, base)*100 )

 

1985

  900  

100

900.00

100.00  

1986

  950  

108

879.63

  97.74  

1987

1020  

117

871.79

  96.87  

1988

1050  

131

801.53

  89.06  

1989

1100  

148

743.24

  82.58  

1990

1200  

155

774.19

  86.02  

1991

1275  

175

728.57

  80.95  

1992

1400  

180

777.78

  86.42  

When the actual time series i.e. nominal wages is deflated using the consumer price index, we find that real wages have been generally decreasing though the nominal wages are increasing. The situation is very well reflected by the real wage index.

Posted Date: 9/17/2012 2:20:34 AM | Location : United States







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