V - Cost-of-living indices

Abstract

This chapter focuses on indices that can be considered good approximations to the functional or true cost-of-living index derived from demand theory. Most official cost-of-living indices are Laspeyres indices. They use as weights the average budget shares of some base period. The criterion that leads to the true cost-of-living index is taken from the theory of consumer demand. The indifference curve is determined with reference to a chosen reference price-income vector, with the help of the direct or the indirect utility function. According to the indirect utility function, a higher utility associated with a given price regime implies a higher income. In these days of rapid inflation, the fact that the Laspeyres index is an upper bound to the true index makes it possible to give an economic interpretation to, and to judge the effectiveness of, practices such as the indexing of wages, rents, mortgage interests, etc., that is, the linkage of these prices to the official index. The computations to approximate the true spatial index with the help of Laspeyres and Paasche indexes can be illustrated from an impressive study made by the Statistical Office of the European Communities to determine purchasing power parities in Europe.