What is an index?
Indexation is a system or technique used by organizations or governments to link prices and asset values. This is done by linking adjustments made to the value of goods, services or other specified values to a predetermined price or composite index. Indexing entails identifying a price index and determining whether linking value to the price index will achieve the goals of the organization. Indexation is most commonly used for wages in high inflation environments. Indexes are also known as upgrades.
- Indexation means adjusting prices, wages, or other values based on changes in another price or a composite measure of prices.
- Indexation can be done to adjust for the effects of inflation, cost of living or input prices over time, or to adjust for different prices and costs in different geographic areas.
- Indexation is often used to raise wages in an inflationary environment, where failure to negotiate regular wage increases will result in a persistent decline in workers’ real wages.
Learn about indexes
Indexing a given price or payment to other prices can be used for two main purposes. It can be used both to maintain stable relative prices between two or more goods or services, and to maintain stable real prices of goods or services relative to the purchasing power of monetary units. Indexing is a pre-specified process, which means that all parties involved generally know how a link works.
In the first and simpler case, this is done by specifying the desired target ratio of two prices and adjusting one price to maintain that ratio when the other price changes. For example, an ice cream stand might tie the selling price of ice cream cones to the wholesale price they pay for ice cream in order to maintain a stable profit margin by keeping the price of the cones supplied relative to the cost of bulk ice cream. In this way, if the wholesale price of the input doubles, the output price will also double, and the business can still be profitable.
In the second case, the price or asset value is linked to the price level of a basket of commodities, which is usually set to 100 at a given point in time. Price indices are usually published by official government agencies, usually for ease of use in the indexation of prices, wages and transfers.
Businesses can use this type of index to match employee wage growth to inflation, meaning that a rise in the consumer price level over time will lead to wage growth. This particular type of indexation is called Cost of Living Increase (COLA).
In the above example, the use of indexation could theoretically mitigate the impact of inflation on workers’ living standards. Without this indexation, most workers would actually get annual cuts in real wages because inflation would reduce the purchasing power of their nominal wages. Economic changes could still force some disparity between wages and inflation rates.
Governments may similarly use indexation as a way to potentially mitigate the negative effects of inflation on transfer payments and rights recipients. For example, Social Security payments are tied to annual increases in the consumer price index.
In addition to indexation over time, prices and wages can also be indexed across different geographic areas. For example, a company with employees in multiple states or cities may need to tie compensation in different regions to local prices, as rent and living costs vary from place to place. This can be done by linking compensation to prevailing wages paid by other businesses in these areas, or using indices such as regional price parity published by the Bureau of Economic Analysis.
Various assets and values may be indexed. Some countries may index certain types of tax payments at different times. For example, it might apply to debt mutual funds that have been held for a certain minimum period of time before selling. In this case, the original purchase price is adjusted for inflation when calculating long-term capital gains that will be taxed when these debt funds are sold. This could result in sellers of such assets receiving tax discounts after the transaction.
Indexation may also be applied to pension funds to assure participants that their assets will keep pace with inflation. This way, the value of these assets does not erode over time.
A life insurance company may offer its customers policies that contain indexing clauses, which may promise inflation-adjusted payouts. However, premiums for such plans may be higher as the year grows. Such a product may raise consumer concerns about premium overruns, especially during times when inflation is at its lowest and below the growth rate charged by indexation.