What is an index?
Indexing is the system or method used by an organization or government to link price to asset value. This is done by linking adjustments made to the value of goods, the price of services, or another specified value to a given price or composite index. Indexing requires you to identify the price index and determine if you can achieve your organization’s goals by linking the values to the price index. Indexing is most commonly used for wages in a highly inflationary environment. Indexing is also known as escalation.
- Indexing means adjusting a price, wage, or other value based on changes in another price or a composite metric of the price.
- Indexing can be done to adjust the impact of inflation, living expenses, or input prices over time, or to adjust different prices and costs in different geographic areas.
- In an inflationary environment, indexes are often used to raise wages in an inflationary environment, as failure to negotiate regular wage increases will continue to reduce real wages for workers.
Indexing a particular price or payment to another price serves two main purposes. It can be used to maintain a stable relative price between two or more goods or services, or to maintain a stable real price of a goods or services relative to the purchasing power of a currency unit. Indexing is a pre-specified process. That is, all involved parties are usually aware of how the link works.
In the first, simpler case, this is done by specifying the desired target ratio of the two prices and adjusting the price of one when the other is changed to maintain the ratio. For example, ice cream stands have stabilized by indexing the selling price of ice cream cones to the wholesale price paid for ice cream and keeping the price of the cones offered constant relative to the cost of bulk ice cream. You can maintain your profit margin. cream. That way, if the wholesale price of the input doubles, the output price doubles, and the business can remain profitable.
In the second case, the price or asset value is linked to the price level of the basket of goods. This is usually set to 100 at a particular point in time. Price indexes are generally published by public government agencies and are often issued for the specific purpose of convenient use in indexing prices, wages, and remittances.
Companies can use this type of index to match employee salary increases to inflation. In other words, rising consumer price levels over a period of time lead to higher salaries. This particular type of index is called Increasing Living Expenses (COLA).
In the above example, in theory, the use of inflation can mitigate the impact of inflation on the standard of living of workers. Without this type of indicator, inflation would reduce the purchasing power of nominal wages, resulting in a substantial reduction in real wages each year for most workers. Economic changes can still create some disparities between salary and inflation paces.
Governments may also use indexes as a way to potentially mitigate the potential negative impact of inflation on remittance payments and eligible recipients. For example, social security payments are linked to the annual rise in the consumer price index.
In addition to indexing over time, prices and wages can be indexed in different geographic areas. For example, rent and living expenses vary from place to place, so companies with employees in multiple states or cities may need to associate compensation from different regions with local prices. This can be done by indexing wages on general wages paid by other companies in these regions, or by using indexes such as regional price parity issued by the Bureau of Economic Analysis.
Various assets and values can be indexed. Some countries may index certain types of tax payments for different periods of time. For example, it may apply to debt mutual funds that have been held for a minimum period of time before being sold. In such cases, the original purchase price will be adjusted to inflation when calculating the long-term capital gains that will be taxed when those bond funds are sold. This can lead to post-transaction tax discounts for sellers of such assets.
You can also apply the index to pension funds to reassure participants that their assets are catching up with inflation. That way, the value of these assets will not be compromised over time.
Life insurers may offer clients policies that include indexing terms that may promise inflation-adjusted payments. However, premiums for such plans can increase as they increase year by year. Such products can raise concerns about consumers overspending premiums, especially during periods of minimal inflation and below the rate of increase imposed on indexing.