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A Laspeyres price index is a measurement tool that compares the price of certain goods or commodities in a base period to a current period. This helps determine the purchasing power of a particular currency, and may also be used to judge a standard of living for certain people. The Laspeyres price index is one of the key tools used by economists for determining the overall health of an economy.
The index was first developed by Etienne Laspeyres (1834-1913), an economist from Germany. He theorized that measuring prices of certain products, and comparing them to an earlier base period could provide some insight into where an economy was headed. He devised a formula that would take the ratio of prices in a current period compared to a base period, and multiply it by 100. At that point, it is then possible to make a comparison.
For example, in a Laspeyres price index, the base year is generally indexed at 100. If prices go up the next year, that year could have an index of 125. In that case, the inflation rate would be 25 percent. The actual amount of money spent on the items is not predicted by the model. Rather, the model is simply used to provide guidance on the value of the currency.
One of the main reasons the Laspeyres price index is not often used to determine quality of life is due to the substitutions consumers may make. If, for example, consumers begin to substitute some items for others, the total cost of expenditures may go down, or remain steady, no matter what the price index is doing. If the consumer is satisfied with the items purchased, then there has been no overall decrease in the quality of life, despite fewer of the original items being purchased.
The items in the Laspeyres price index may change from time to time, depending on the purchasing habits of consumers. Generally, those in charge of determining the price index try to choose high-demand items, as well as necessities. This helps by ensuring that the price index basket is filled with products for which demand is relatively consistent.
As with most indexes, the Laspeyres price index is a subjective measurement because of the items chosen for review. Therefore, another index may come to a slightly different conclusion. Indexes are not meant to provide a direct measurement of inflation, but rather give a snapshot of the general direction. As with all macroeconomic measurements, the situation of each individual can be substantially different.