Inflation Measurement and Adjustment
If you roll your eyes when you hear an elderly person talk about how everything used to be so much cheaper back in the day, then you probably understand “inflation.”
Inflation is a given in our capitalist economy today, which means people expect prices (and ideally, wages) to go up about 2% each year, give or take. While prices appear to be rising, that doesn’t necessarily mean things are actually getting more expensive, since your income is also probably rising along with inflation.
To actually figure out the value of what your money can buy at any given time, you have to measure and adjust for inflation. In the U.S., inflation is usually measured by the Consumer Price Index (CPI) and Producer Price Indexes (PPI). These are two general indexes that measure the prices of what things (groceries, gas, clothing, etc.) cost over time. Basically, they’re really large surveys taken regularly to track changes in prices of general goods over time.
For instance, since 1985, the CPI has risen about 115%, while college costs have risen about 500%. That means college is a lot more expensive in real value than it was in the late ‘80s after adjusting for inflation. It also means you can tell your older relatives who complain about millennials complaining about college debt to suck it, because it’s not possible to pay off college with a side job like they did.
If you’re an investor, you’ll want to calculate the inflation-adjusted return of your gains to understand the real value you’ve gained. If you simply look at the numbers in nominal terms without adjusting for inflation, you won’t be getting an accurate picture of how much money you’ve really made. Cha-ching.
Related or Semi-related Video
Econ: What are Real v. Nominal Wages?0 Views
And finance Allah shmoop What are riel versus nominal wages
Well old Grandpa Larry has been retired for a while
so he's a bit out of touch When I was
your age burgers cost a quarter Now they're five dollars
five dollars Everything so expensive nowadays Oh Grandpa and guess
There he goes again being either sarcastic or totally not
getting that Inflation is a you know a thing Well
inflation is the reason prices and wages or nominal wages
to be precise there That's the reason they rise Inflation
Your nominal wage is the actual dollar amount on your
paycheck And on Grandpa you know when he a bad
one for you Maybe it's a three grand a month
for grandpa while it was three grand for the whole
year So grandpas not exactly wrong Everything was in fact
cheaper nominally cheaper back in the day But nominal incomes
were also lower Today the sticker price on everything is
much higher but so are our paychecks Where grandpa is
steered wrong is that well he's only thinking of prices
rising not income if prices rise But buying power also
rises Well then things aren't necessarily Mohr expensive or at
least not relatively more expensive What Grandpa doesn't get is
that he's looking at nominal wage rates when he should
be looking at the real wage rate Well the rial
wage rate is the money you make once you take
into account the effects of inflation on buying power While
your nominal paycheck is much larger than grandpas while you're
really wage rate might be pretty similar to what his
was in the nineteen fifties Riel wage rates allow us
to compare the amount of buying power different people have
or well had And that's what counts right Sure you
can buy a lot of things if you're a millionaire
today But as inflation raises prices for many decades down
the line being a quote millionaire unquote in nominal terms
it might be pretty average inflation which is what creates
the difference between nominal and real wages is the reason
you really really shouldn't save up cash in your sock
drawer under your match Chris was just sitting there doing
nothing You're much better off keeping your money somewhere where
it can at least gain a little interest income ideally
enough to keep up with inflation which is around two
or three percent a year on most years Think about
it this way If Grandpa Larry put a five dollar
bill in his sock drawer in the nineteen fifties that
five dollars was worth twenty burgers at the time right
A quarter a burger If he took out that same
five dollar bill from his sock drawer today he'd only
be able to buy one burger with it Just won
all that inflation over all those years Eroded the burger
buying value of that five dollar bill from twenty burgers
down to a single burger If you want to keep
your buying power up while the money you have lying
around needs to earn a two or three percent interest
a year if your nominal savings keeps up with inflation
while your riel savings will retain its riel buying power
If Grandpa Larry put that five dollars in the bank
accounts that yielded me let's call it two percent Well
then he'd be able to buy a lot more with
it than just one burger today Although he's not totally
wrong about burgers that is getting more expensive If you'd
put that five dollars in a bank account seventy years
ago and it grew a two percent a year well
at five dollars would now be twenty dollars which means
it grew three hundred percent of the price of burgers
though rose from a quarter to five dollars in the
same time which comes out Tio nineteen hundred percent well
While his five dollars was keeping up with inflation it
wasn't growing as fast as the cost of burgers So
the rial price of burgers actually did go up Even
on a relative basis The Consumer Price index helps us
see real price changes like these For instance the real
price of college and health care have risen by a
substantial amount way higher than the rate of inflation That
means it takes more buying power than it did before
to pay for those things which is a bigger cut
out of people's paychecks than ever before So maybe Grandpa
Larry is an entirely senile yet after all but he's
getting there
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