1. 4.6 There are two basic types of indices used to mea sure changes in price levels over time: the Laspeyres1 Index and the Paasche Index. The Harmonized Index of Consumer Prices is used in the euro area to measure changes in the cost of living due to infla tion. It is a Laspeyres-type price index. So too is the Consumer Price Index used in India, as are the indices used in most countries to measure inflation.

However, Laspeyres-type indices overestimate the amount of extra income needed to compensate for price increases because they focus on the cost of a standard bundle (or basket) of goods. A true cost-of-living adjustment would rather hold utility constant. Use a graph to illustrate that an individ ual’s utility rises if we increase the person’s income by the amount by which a Laspeyres-type index estimates the rate of inflation when compared to the true cost-of-living index.