Economists often make comparisons between sets of data across time. For example, a macroeconomist might want to measure changes in the cost of living in the United States over a five-year period. This is where index numbers may come in. They allow for quick and easy comparisons by identifying a "base year" and scaling all of the other results off of that year.
The Role of Index Numbers
The primary role of index numbers is to simplify otherwise complicated comparisons. It is especially useful when comparing currencies that have lots of different nominal values. Some countries even use index numbers to modify public policy, such as adjusting government benefits for inflation.
The nice thing about index numbers is they can be modified to any unit of measurement. Economists can apply indexing methods to prices, incomes, production, employment and unemployment, net exports or inflation.
Understanding the Index Number Method
Take the example of an economist tracking changes in the cost of living over five years. Suppose the first year in the study is 2010, when it hypothetically costs an American family of four $33,125 to afford basic housing, food, clothing, utilities, gasoline and health care.
Without context, that $33,125 number does not really mean much. It is also a difficult number to scale. If in the following year, the average cost of living increased to $34,781, it is not immediately obvious just how exponential of an increase occurred.
To simplify things, the economist changes the $33,125 to the base number, which is usually set at 100. All other numbers are similarly scaled down. In this example, the value for the second year is changed from $34,781 to 1.05, or a 5% increase from the prior year.