Paasche IndexOverview, Formula, How to Calculate and Examples

Written By:
Lisa Borga

Reviewed By:
FundsNet Staff

The Paasche Price Index is a way of calculating inflation by measuring changes in the price of a commodity as compared to its price in a base year.

The Paasche Price Index, also known as the current weighted index, was developed by a 19^th-century German economist.

The Paasche Price Index Explained

This index looks at a specific bundle of commodities in the current year and measures the change in price as compared to a base year.

By comparing the cost of a specific selection of commodities in the current year to the price in a base year, it can show the amount of inflation that has occurred.

The Paasche Price Index typically uses a base year of 100. If a period has an index of over 100, this indicates inflation.

In contrast, if a period has an index below 100, it would indicate deflation.

The base year is represented as year 0, whereas the year for which the index is being calculated is the observation year.

The Paasche Price Index is typically used by economists to evaluate the economic growth of a country by looking at the inflation of its services and goods.

This index is frequently confused with another index called the Laspeyres Price Index.

The primary difference between these two indexes is that the Laspeyres Price Index uses base-period quantity weightings, whereas the Paasche Price Index uses current-period quantity weightings.

Paasche Price Index Formula

Paasche Price Index Formula = Sum ( observation price * Observation Quantity) / (Base Price * Observation Quantity)

Where:

Observation Price = The price in the period that the index is being calculated for

Observation Quantity = The quantity in the period that the index is being calculated for

Base Price = Price at year zero

Paasche Price Index Example

Here is an example that shows how to calculate the Paasche Price Index for the commodities X, Y, and Z.

Here is how to compute the Paasche Price Index.

The Index for Year Zero is 100.

Year One

Year One = [($25*40) + ($30*45) + ($35*50)] / [($15*40) + ($25*45) + ($35*50)] = 117.98%

The Paasche Price Index for Year One is 117.98%.

Year Two

Year Two = [($40*45) + ($45*55) + ($50*60)] / [($15*45) + ($25*55) + ($35*60) = 175.30%

The Paasche Price Index for Year Two is 175.30.

This example shows the effect of inflation on commodities.

As shown, the prices for the commodities X, Y, and Z observed together increased by 117.98% as of the end of the first year and by 175.30 by the end of the second year.

Advantages & Disadvantages of the Paasche Price

Advantages

The Paasche Price Index is a good tool for measuring inflation, and it has a number of advantages, such as:

• It looks at a specific selection of commodities, both the higher and lower-cost items.
• The index focuses primarily on consumption habits.
• It acts as a warning for the government concerning rising prices as well as an increasing cost of living.
• The government uses this index for policy formation.
• The index is helpful for monitoring the cost of living and general price levels.

Disadvantages

Although the Paasche Price Index has several advantages, it has some disadvantages as well, such as:

• It does not account for growth in the economy between the two periods.
• The index does not consider the changing tastes or preferences of consumers.
• It costs more to use than the Laspeyres Price Index.
• It is difficult to obtain the base year price.

Final Thoughts

The Paasche Price Index is an important ratio for considering the rate of inflation for a specific selection of commodities.

This index is computed monthly so as to spot any trends, such as whether inflation is dropping or increasing.

It gives officials the opportunity to address any important trends in inflation and consider how any policies would affect people.

Key Takeaways

• The Paasche Price Index is a composite price index that is used to measure the change in the quantities and prices of a specific selection of commodities.
• The index corrects for the bias toward higher prices in the Laspeyres Price Index.
• The data necessary for calculating the Index can be difficult to obtain.
• The Paasche Price Index considers consumption patterns.
• The Paasche Price Index tends to understate price changes.