TIME SERIES AND INDEX NUMBERS
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Introduction
• Time series is a sequence of observations in specific order but these observations are time
dependent.
• In different sectors like Economics, Commerce and Environment events happen over some time.
For example- the temperature of a day at different time intervals and price of the commodity in
one month to another month or it may be a day or year, production of crop varies over year,
production of an item in an industry increases or decreases depending on the demand of the
product, sale of goods depend upon the price as well as need of the product over the time like in
change of technology, consumption of items increase with increase in earning over time or
decrease due to lack of money like visit to hotels depends upon person’s earning that varies over
time.
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Definition
• “A Time Series is a set of statistical observations arranged in chronological order”
by Morris Hamburg.
• “A time series may be defined as a collection of reading belonging to different
periods, of some economic variables or composite of variables” by Ya-lun Chou.
• “Time series is a chronological sequence of observations of quantitative variables
that are recorded successively at regular and specified time interval”.
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UTILITY OF TIME SERIES
1) It helps in understanding the past behavior of the time series: to
understand the past behavior of any time series, to analyze variation between
data sets over some time.
2) It helps in future prediction: by observing past behavior of time series data
we may see how observation are varying. According to the behavior of data,
one can use this information for forecasting. We know that time series depend
on past data. For better prediction of values, one requires a long period of data.
3) It helps in understand current situation of the problem: the actual
performance can be analyzed by taking difference between expected
performance and cause of variation of the data.
4) It facilitates comparisons between different time series
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Components of Time Series
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Secular trend
The increase or decrease in the movements of a time series is called a Secular trend. A time series data
may show an upward trend or downward trend for a period of years and this may be due to factors like:
• Increase in population,
• Change in technological progress,
• Large-scale shift in consumer demands
For example,
• population increases over some time, price increases over a period of years, and production of goods
on the capital market of the country increases over a period of years. These are examples of an upward
trend.
• The sales of a commodity may decrease over some time because of better products coming to the
market. This is an example of a declining trend or downward.
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Seasonal Variation
Seasonal variations are short-term fluctuations in time series that occur periodically
in a year. This continues to repeat year after year.
• The major factors are weather conditions and the customs of people.
• More woolen clothes are sold in winter than in the season of summer.
• Each year more ice creams are sold in summer and very little in Winter season.
• The sales in the departmental stores are more during festive seasons than in the
normal days.
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Cyclic Variations
• Cyclical variations are recurrent upward or downward movements in a time series
but the period of cycle is greater than a year. Also these variations are not regular
as seasonal variation.
• A business cycle showing these oscillatory movements has to pass through four
phases-prosperity, recession, depression and recovery. In a business, these four
phases are completed by passing one to another in this order.
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Irregular Variations
Irregular variations are fluctuations in time series that are short, erratic in nature and
follow no regularity in the occurrence pattern. These variations are also referred to
as residual variations since by definition they represent what is left out in a time
series after trend, cyclical, and seasonal variations. Irregular fluctuations result due
to the occurrence of unforeseen events like :
• FLOODS,
• EARTHQUAKES,
• WARS,
• FAMINES
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Measurement of Trend: Method of Least Squares
• Least square method is the process of finding a regression line or best-fitted line
for any data set that is described by an equation.
• This method requires reducing the sum of the squares of the residual parts of the
points from the curve or line and the trend of outcomes is found quantitatively.
• The method of curve fitting is seen while regression analysis and the fitting
equations to derive the curve is the least square method.
Eg., analyzing a company's sales data over time to identify the overall growth trend,
where you would plot sales figures (dependent variable) against time (independent
variable) and use the least squares method to find the best-fit line, showing the
general upward or downward trend in sales over time.
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Contn.,
• The least-squares method is a statistical method used to find the line of best fit of the form of an
equation such as y = mx + b to the given data.
• The curve of the equation is called the regression line. Our main objective in this method is to
reduce the sum of the squares of errors as much as possible. This is the reason this method is
called the least-squares method.
• This method is often used in data fitting where the best fit result is assumed to reduce the sum of
squared errors that is considered to be the difference between the observed values and
corresponding fitted value.
• The sum of squared errors helps in finding the variation in observed data.
• The two basic categories of least-square problems are ordinary or linear least squares and
nonlinear least squares.
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Limitations for Least Square Method
Even though the least-squares method is considered the best method to find the line
of best fit, it has a few limitations. They are:
• This method exhibits only the relationship between the two variables. All other
causes and effects are not taken into consideration.
• This method is unreliable when data is not evenly distributed.
• This method is very sensitive to outliers. In fact, this can skew the results of the
least-squares analysis.
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Parabolic Trend
A parabolic trend in a time series is a non-linear trend that describes a change in the
amount of change that is constant per unit of time.
The mathematical form of a parabolic trend is Yt = a + bt + ct2, where a, b, and c are
constants that are determined from the given data.
In simpler terms, a parabolic trend shows a pattern where the rate of change itself is
changing—specifically, it increases or decreases at an accelerating rate.
Eg., Stock Prices of a High-Growth Company:
• Imagine a high-growth technology company whose stock price is initially low but
grows rapidly as the company becomes more successful. Initially, the stock price
might rise slowly, but as the company gains more traction and its earnings grow, the
price starts to increase at an accelerating rate. If you plot this stock price over time,
the graph might form a parabolic shape, reflecting the accelerated growth.
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Logarithmic Trendline
• A logarithmic trendline is a best-fit curved line that is most useful when the rate of
change in the data increases or decreases quickly and then levels out. A
logarithmic trendline can use negative and/or positive values.
• Mathematically, this is represented as Y = m1*ln(X) + C
Eg., Consider the adoption of new technology or innovation. When a new
technology is introduced, early adopters start using it, and adoption grows rapidly.
However, as the technology matures and reaches a larger audience, the rate of new
adopters slows down, leading to a logarithmic trend. For example, the adoption of
smartphones had a rapid growth phase initially, which then slowed as the market
became saturated.
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Index Number
• An index number is a method of evaluating variations in a variable or group of variables
in regards to geographical location, time, and other features.
Eg., Suppose the base value of the Housing Price Index for New York is 100 in 2022. By
2023, the index in New York is 110, while in a different city, it’s 95. This means that
housing prices in New York have increased by 10% from 2022, whereas in the other city,
prices have decreased by 5%. This comparison helps you understand regional variations in
housing costs.
• There are various kinds of index numbers. However, at present, the most relatable is the
price index number that particularly indicates the changes in the overall price level (or in
the value of money) for a particular time.
(PI - A price index (PI) is a measure of how prices change over a period of time, or in other words, it
is a way to measure inflation. )
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• Here, the value of money is not constant, even if it falls or rises it will
affect and change the price level. An increase in the price level
determines a decline in the value of money. A decrease in the price
level means an increase in the value of money.
Eg., If a loaf of bread cost $2 last year, it would cost $2.10 this year (an increase of
5%). With your $100, you could buy 50 loaves of bread last year, but only 47.62
loaves this year due to the higher prices.
• Therefore, the differences in the value of money are indicated by the
differences in the overall price level for a particular time. Therefore,
the changes in the overall prices can be evaluated by a statistical
device known as ‘index number.’
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Definition of Index Number
• According to Croxton and Cowden, index numbers are devices for measuring
differences in the magnitude of a group of related variables.
• According to Spiegal, an index number is a statistical measure designed to show
changes in a variable or a group of related variables concerning time, geographical
locations, or other characteristics.
Types of Index Number
• Price index number: It evaluates the relative differences in costs between two particular
points in time.
• Quantity index number: It measures the differences in the physical quantity of the
product’s manufacturing, buying, or selling of one item or a group of items.
(Note: Price index numbers measure and allow for comparison of the prices of certain goods while quantity
index number measure the changes in the physical volume of production, construction or employment.)
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Significance of Index Numbers
1. Expressed in Percentage
• A change in terms of the absolute values may not be comparable.
• Index numbers are expressed in percentage, so they remove this barrier.
• It is possible to compare the agricultural production and industrial production and
at the same time being expressed in percentage, we can also compare the change
in prices of different commodities.
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Contn.,
2. Relative measures or measures of net changes
• Index numbers measure a net or relative change in a variable or a group of
variables.
• For example, if the price of a certain commodity rises from ₹10 in the year
2007 to ₹15 in the year 2017, the price index number will be 150 showing that
there is a 50% increase in the prices over this period.
3. Measure change over a period of time or in two or more places
• Index numbers measure the net change among the related variables over a
period of time or at two or more places.
• For example, change in prices, production, and more, over the two periods or
at two places.
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Contn.,
4. Specialised average
• Simple averages like, mean, median, mode, and more can be used to compare the
variables having similar units.
• Index numbers are specialised average, expressed in percentage, and help in measuring
and comparing the change in those variables that are expressed in different units.
• For example, we can compare the change in the production of industrial goods and
agricultural goods.
5. Measuring changes that are not directly measurable
• Cost of living, business activity, and more are complex things that are not directly
measurable.
• With the help of index numbers, it is possible to study the relative changes in such
phenomena.
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Problems in Construction of Index Numbers
1. Purpose of index numbers
• Many different types of index numbers are constructed with different objectives.
• Example: Price index, quantity index, consumer price index, wholesale price index, and
more
• So, the first important issue/problem is to define the objective for which the index number
is to be constructed.
2. Selection of base period
• Base period is the period against which the comparisons are made.
• Selection of a suitable base period is a very crucial step.
• It should be of reasonable length and normal one, i.e., it should not be affected by any
abnormalities like, natural calamities, war, extreme business cycle situations.
• It should neither be too close nor too far.
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Contn.,
3. Selection of commodities
• All the items cannot be included in the construction of an index number.
• Nature and number of items to be included in an index number depends upon the type of
index to be constructed.
• For example, to construct a ‘consumer price index’ those commodities should be
considered that are generally consumed and the number should be neither too small nor
too big.
4. Selection of sources of data
• Depending upon the type of index numbers, the correct source should be selected for data.
• Like, to construct CPI, we need retail prices and to construct the wholesale price index,
we need wholesale prices. Accordingly, the right and reliable source should be selected.
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Contn.,
5. Selection of weights
• The term ‘weight’ refers to the relative importance of different items in the
construction of index numbers.
• All the items do not have the same importance.
• So, it is necessary to adopt some suitable measures to assign weight.
6. Selection of an appropriate formula
• There are various formulas for construction of index numbers like
Laspeyres’ method, Paasche’s method, Fisher’s method, and more.
• No single formula is appropriate for all types of index numbers.
• The choice of formula depends upon the purpose of the available data.
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Methods of Constructing Index Numbers
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Unweighted or simple index
numbers
An Index Number in which each item must have some weight as, no weight is expressly assigned to
any item is known as Unweighted Index Number. It is also known as Simple Index Number and
can be constructed with the help of two techniques; viz., Simple Aggregative Method and Simple
Average of Price Relatives Method.
i) Simple Aggregative Method:
A method in which the aggregate prices of all the selected commodities in the current year are
expressed as the aggregate price of all the commodities in the base year is known as Simple
Aggregative Method. It is the simplest method to construct index number. The formula for
constructing index number is:
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Contn.,
Example:
From the following data, construct Index Numbers for 2018-2019, taking 2010-2011 as the base year
by using the Simple Aggregate Method.
The value of the Price Index (140) reveals that in the year 2018-2019, there is a net increase of 40% in
the prices of given commodities as compared to the year 2010-2011.
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ii) Simple Average of Price Relatives Method:
This index number is an improvement over the previous method, as it is not affected by the unit in
which the prices of the commodities are quoted. The formula for constructing index number is:
The Price Index Number (137.9) shows that there is an increase of
37.9% in the prices of commodities in the year 2018-2019 as
compared in the year 2010-2011.
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Weighted Index Number
• In other index numbers, equal importance is given to each item. However, under
Weighted Index Number, rational weights are given to each commodity or item
explicitly.
• These weights indicate the relative importance of the commodities or items
included in the determination of the index.
• There are two methods through which Weighted Index Numbers can be
constructed; viz.,
i) Weighted Aggregative Method and
ii) Weighted Average of Price Relatives Method.
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i) Weighted Aggregative Method
• This method involves assigning weights to different items and obtaining weighted
aggregate of the prices instead of finding a simple aggregate of prices.
• Some important methods of constructing Weighted Aggregative Index are as
follows:
1. Laspeyre’s Method
2. Paasche’s Method
3. Fisher’s Ideal Method
4. Drobish and Bowley’s Method
5. Marshall Edgeworth Method
6. Walsch’s Method
7. Kelly’s Method
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a) Laspeyre’s Method
• The method of calculating Weighted Index Numbers under which the base year quantities
are used as weights of different items is known as Laspeyre’s Method.
Example: The following are the price and quantity of four commodities A, B, C, and D, in 2015 and
2020. Construct index number of prices in the year 2020 using Laspeyre’s Method.
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b) Paasche’s Method
• The method of calculating Weighted Index Numbers under which the current year’s quantities are
used as weights of different items is known as Paasche’s Method.
Example:
The following are the price and quantity of four commodities A, B, C, and D, in 2015 and 2020.
Construct index number of prices in the year 2020 using Paasche’s Method.
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c) Fisher’s Method
The method of calculating Weighted Index Numbers under which the combined techniques of Paasche and
Laspeyre are used is known as Fisher’s Method. In other words, both the base year and current year’s
quantities are used as weights. Fisher’s Method is considered the Ideal Method for Constructing Index Numbers.
Example:
The following are the price and quantity of four commodities A, B, C, and D, in 2015 and 2020. Construct index
number of prices in the year 2020 using Fisher’s Method.
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ii) Weighted Average of Price Relatives Method
• Under this method, the base year prices of the commodities are taken as the basis to calculate the price
relatives for the current year. The calculated price relatives are then multiplied by their respective weights of
the items. After that, the products determined are added up and divided by the sum of weights.
Example:
• Use Weighted Relatives Method and determine the index number from the following data for the year 2019
with 2008 as the base year.
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Test of Adequacy of Index Numbers
• So far we have discussed various formulae for construction of weighted &
unweighted index numbers. However the problem still remains of selecting an
appropriate method for the construction of an index number in a given situation.
• The following tests can be applied to find out the adequacy of an index number.
(1) Unit Test
(2) Time Reversal Test
(3) Factor Reversal Test
(4) Circular Test
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Contn.,
1. Unit Test
• This test requires that the index number formulae should be independent of the
units in which prices or quantities of various commodities are quoted.
• For example in a group of commodities, while the price of wheat might be in kgs.,
that of vegetable oil may be quoted in per liter & toilet soap may be per unit.
• Except for the simple (unweighted) aggregative index, all other formulae
discussed above satisfy this test.
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2. Time Reversal Test
• The time reversal test is used to test whether a given method will work both backward & forward with
respect to time.
• The test is that the formula should give the same ratio between one point of comparison & another no
matter which of the two is taken as the base.
• The time reversal test may be stated more precisely as follows— If the time subscripts of a price (or
quantity) index number formula are interchanged, the resulting price (or quantity) formula should be
reciprocal of the original formula. i.e. if p represents the price of the year 2011 and p represents the price
of the year 2012.
The Time Reversal Test is satisfied when
1
P01 = --------- or P 01 X P10 = 1
P10
Where,
P01 = Price index for the year one with zero as the base
P10 = Price index for the year zero with one as the base
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Contn.,
The methods which satisfy the following test are:-
(1) Simple aggregate index
(2) Simple geometric mean of price relative
(3) Weighted geometric mean of price relative with fixed weights
(4) Kelly’s fixed weight formula
(5) Fisher’s ideal formula
(6) Marshall-Edgeworth formula
This test is not satisfied by Laspeyres’ method & the Paasche’s method as can be seen from below:
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Contn.,
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3. Factor Reversal Test
• An Index number formula satisfies this test if the product of the Price Index and the Quantity Index gives
the True value ratio, omitting the factor 100 from each index.
• This test is satisfied if the change in the price multiplied by the change in quantity is equal to the change
in the value.
• Speaking precisely if p and q factors in a price (or quantity) index formula be interchanged, so that a
quantity (or price) index formula is obtained the product of the two indices should give the true value
ratio.
The factor Reversal Test is satisfied when
∑ p1 q1
P01 X Q01 = ---------
∑ p0 q0
Where,
P01 = Price index for the year one with zero as base
Q01 = Quantity index for the year one with zero as base
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This test is not satisfied by Laspeyre, Paasche’s formula and Marshall-Edgeworth. But this test is satisfied by
Fisher’s Ideal Index.
Laspeyre’s Formula :
∑ p1 q 0
P01 = --------- X 100
∑ p0 q0
∑ q1 p 0
Q01 = --------- X 100
∑ q0 p0
∑ p1 q1
P01 X Q01 ≠ ---------
∑ p0 q0
The Laspeyre’s Formula does not satisfied the FRT.
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Paasche’s formula
∑ p1 q 1
P01 = --------- X 100
∑ p0 q1
∑ q1 p 1
Q01 = --------- X 100
∑ q0p1
∑ p1 q 1
P01 X Q01 ≠ ---------
∑ p0 q0
The Paasche’s Formula does not satisfied the FRT.
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Fisher’s formula
__________________
∑ p1 q0 ∑ p1 q 1
P01 = --------- X ---------- X 100
∑ p0 q0 ∑ p0 q1
___________________
∑ q 1 p0 ∑ q1 p1
Q01 = --------- X ---------- X 100
∑ q0 p0 ∑ q0 p1
∑ p1 q1
P01 X Q01 = ---------
∑ p0 q0
The fisher’s Formula does satisfied the FRT.
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4. Circular Test
• Circular test is an extension of time reversal test for more than two periods & is based on
shiftability of the base period.
• According to this test, if there are three time periods 0,1,2 and price index od period 1 relative to 0
(P01), price index of period 2 relative to period 1 (P12) and price index of period 0 relative to period
2 (P20) are computed, then the product of these three indices must be unity.
Symbolically:
P2 P0
P01 X P12 X P20 = 1
P1
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Contn.,
• This test is satisfied only by the following index Nos. formulas—
1. Simple aggregative index
2. Simple geometric mean of price relatives
3. Kelly’s fixed base method When the test is applied to simple
aggregative method.
• Hence, the simple aggregative formula satisfies circular test Similarly
when it is applied to fixed weight Kelly’s method
• This test is not satisfied by Fishers ideal index.
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Chain Index Numbers
• According to the fixed base methods, the base remains the same and
unchangeable throughout the series.
• But, as the time passes some items may be added in the series while
some may be deleted. It, therefore, becomes tough to compare the
result of the current conditions with that of the past period.
• Thus, in such a situation changing the base period is more appropriate.
Chain Index Numbers method is one such method
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Contn.,
• Here's how chain index numbers are calculated:
[Link] the figures for each year as a percentage of the previous
year. These are called Link Relatives.
[Link] the Link Relatives together in a chain to form the chain
index.
[Link] base year changes every year, so for example, the base year for
2001 is 2000, and the base year for 2002 is 2001.
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Contn.,
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Contn.,
• Advantages of Chain Index Numbers Method
1. This method allows the addition or introduction of the new items in the series and also the deletion
of obsolete items.
2. In an organization, management usually compares the current period with the period immediately
preceding it rather than any other period in the past. In this method, the base year changes every
year and thus it becomes more useful to the management.
• Disadvantages of Chain Index Numbers Method
1. Under this method, if the data for any one of the year is not available then we cannot compute the
chain index number for the subsequent period. This is so because we need to calculate the link
relatives, which are not possible to be calculated in this case.
2. In case an error occurs in the calculation of any of the link relatives, then that error gets
compounded and all the subsequent link relatives will also become incorrect. Thus, the entire
series will give a misrepresented picture.
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