Paasche Index

What is the Paasche Price Index?

Paasche Price Index is defined as a methodology to calculate Inflation by measuring the Price change in a Commodity as compared to the base year. It was invented by Hermann Paasche, an Economist from Germany to understand the Actual Inflation in the Basket of Goods compared to the base year value.

  • The Index generally uses a base year of 100 to analyze the Index.
  • An index greater than 100 signifies the Inflation impact and an Index less than 100 implies Deflation.
  • Year 0 will be termed as Base Year while Calculating Year will be termed as Observation Year.
  • It is commonly used by Economist to analyze the Economic Growth of the Country taking into consideration the Inflation in the Goods and Services.

Paasche Price Index Formula

Paasche Price Index Formula = Sum ( Observation Price * Observation Qty) / (Base Price * Observation qty)

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For eg:
Source: Paasche Index (wallstreetmojo.com)

  • Here Observation Price refers to the Price at the Current Levels for which the Index needs to be calculated.
  • Here Observation Qty refers to the Qty at the Current Levels for which the Index needs to be calculated.
  • Here Base Price refers to the price at Year 0 which is known as the Base Year for calculating the Index.

Example of Paasche Price Index

You can download this Paasche Index Excel Template here – Paasche Index Excel Template

Let us take the below-mentioned Example to understand the Computation of the Paasche Index for a Commodity A, B & C.

 PricesQuantity
CommodityYear 0Year 1Year 2Year 0Year 1Year 2
A$10$30$60203040
B$20$40$70253545
C$30$50$80204050

Solution:

Below mentioned are the Steps to calculate Paasche Index.

Paasche Price Index at Year 0 = 100

The calculation of the Paasche Price Index for Year 1.

Paasche Price Example 1-1

Paasche Price Index at Year 1 = {(30*30)+(40*35)+(50*40)} / {(10*30)+(20*35)+(30*40)}

= 195.45%

The Calculation of Paasche Price Index for Year 2.

PaaschePrice Example 1-2

Paasche Price Index at Year 2 = {(60*40)+(70*45)+(80*50)} / {(10*40)+(20*45)+(30*50)}

= 341%

Hence we can observe the Inflation Impact in the Commodities the prices of Commodities A, B& C observed collectively have been increased by 341% at the end of year 2 and 195% at the end of year 1.

Advantages

Paasche Index is one of the most important tools to observe the Inflation in the basket of Goods and Services by comparing the Current Levels and Quantity available with the Base year prices. Below mentioned are some of the major advantages of its Ratio :

  • It focuses more on the Consumption patterns in the Economy by taking into account the Current level of Quantities available for the same.
  • It takes into account the Entire Basket of Goods and Services which includes Goods at a lower cost and higher Cost both
  • It gives a reflection of the governmental policies on daily goods and services since the same is been consumed by the common public every day and that what matters them the most.
  • Gives a trigger or a warning signal to the government about rising prices and increased cost of living which may hamper growth for a certain class of people.
  • Is a good parameter to frame the Future Policies that will control Inflation.

Disadvantages

Following are the disadvantages of Paasche Index.

  • Does not take into account the changing taste and Preferences of the people.
  • Ignores the Growing Economy
  • Data for the Current Quantities available is very much difficult to extract from multiple Websites
  • A Costlier Process to execute

Limitations of Paasche Price Index

Below are the limitations of Paasche Index.

  • It gives more weight age to the Current Quantity of the Goods.
  • It ignores the Economical growth since the Goods and Services form part of the GDP and lowering their prices about a certain level can have an impact on the Country’s GDP.
  • Prices Tend to rise on a yearly basis keeping in mind the Consuming patterns and Rising Standard of Living among the people
  • Deciding the Base Year is a challenge since its value will be 100. So which year to be Selected for the Year 0 itself is a debatable issue.

Points to Note

A significant Change in the Paasche Price Index will give a Warning Signal to the government Authorities that some action needs to be taken for its Sudden increase or sudden fall. A very high increase in the Index may turn detrimental to the Interest of the Common people to buy the Essential Commodities at high prices.

Conclusion

Paasche Price Index is one of the key ratios in order to determine the velocity of Inflation in the Basket of Goods and Services. It is calculated on a monthly basis to understand the Trend whether it is going in the upward or the downward direction along with the necessary steps or actions to be taken to maintain the same.

This index is been widely used in the Economical Work and the Finance Ministry in order to be aware of the Inflation trends so that the Future Plans and policies would be drafted keeping in mind the Paasche Price Index Ratio worked out and analyzing its impact on the Economy and on the Common people.

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