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

00:00

And finance Allah shmoop What are riel versus nominal wages

00:09

Well old Grandpa Larry has been retired for a while

00:12

so he's a bit out of touch When I was

00:14

your age burgers cost a quarter Now they're five dollars

00:18

five dollars Everything so expensive nowadays Oh Grandpa and guess

00:22

There he goes again being either sarcastic or totally not

00:26

getting that Inflation is a you know a thing Well

00:29

inflation is the reason prices and wages or nominal wages

00:32

to be precise there That's the reason they rise Inflation

00:36

Your nominal wage is the actual dollar amount on your

00:38

paycheck And on Grandpa you know when he a bad

00:41

one for you Maybe it's a three grand a month

00:43

for grandpa while it was three grand for the whole

00:46

year So grandpas not exactly wrong Everything was in fact

00:50

cheaper nominally cheaper back in the day But nominal incomes

00:54

were also lower Today the sticker price on everything is

00:57

much higher but so are our paychecks Where grandpa is

01:00

steered wrong is that well he's only thinking of prices

01:03

rising not income if prices rise But buying power also

01:07

rises Well then things aren't necessarily Mohr expensive or at

01:10

least not relatively more expensive What Grandpa doesn't get is

01:13

that he's looking at nominal wage rates when he should

01:16

be looking at the real wage rate Well the rial

01:19

wage rate is the money you make once you take

01:21

into account the effects of inflation on buying power While

01:24

your nominal paycheck is much larger than grandpas while you're

01:27

really wage rate might be pretty similar to what his

01:30

was in the nineteen fifties Riel wage rates allow us

01:33

to compare the amount of buying power different people have

01:36

or well had And that's what counts right Sure you

01:39

can buy a lot of things if you're a millionaire

01:41

today But as inflation raises prices for many decades down

01:45

the line being a quote millionaire unquote in nominal terms

01:49

it might be pretty average inflation which is what creates

01:51

the difference between nominal and real wages is the reason

01:55

you really really shouldn't save up cash in your sock

01:58

drawer under your match Chris was just sitting there doing

02:01

nothing You're much better off keeping your money somewhere where

02:04

it can at least gain a little interest income ideally

02:07

enough to keep up with inflation which is around two

02:09

or three percent a year on most years Think about

02:11

it this way If Grandpa Larry put a five dollar

02:14

bill in his sock drawer in the nineteen fifties that

02:16

five dollars was worth twenty burgers at the time right

02:19

A quarter a burger If he took out that same

02:22

five dollar bill from his sock drawer today he'd only

02:24

be able to buy one burger with it Just won

02:27

all that inflation over all those years Eroded the burger

02:30

buying value of that five dollar bill from twenty burgers

02:33

down to a single burger If you want to keep

02:35

your buying power up while the money you have lying

02:38

around needs to earn a two or three percent interest

02:40

a year if your nominal savings keeps up with inflation

02:44

while your riel savings will retain its riel buying power

02:48

If Grandpa Larry put that five dollars in the bank

02:51

accounts that yielded me let's call it two percent Well

02:53

then he'd be able to buy a lot more with

02:55

it than just one burger today Although he's not totally

02:58

wrong about burgers that is getting more expensive If you'd

03:01

put that five dollars in a bank account seventy years

03:04

ago and it grew a two percent a year well

03:06

at five dollars would now be twenty dollars which means

03:08

it grew three hundred percent of the price of burgers

03:11

though rose from a quarter to five dollars in the

03:14

same time which comes out Tio nineteen hundred percent well

03:18

While his five dollars was keeping up with inflation it

03:20

wasn't growing as fast as the cost of burgers So

03:23

the rial price of burgers actually did go up Even

03:27

on a relative basis The Consumer Price index helps us

03:29

see real price changes like these For instance the real

03:32

price of college and health care have risen by a

03:34

substantial amount way higher than the rate of inflation That

03:38

means it takes more buying power than it did before

03:40

to pay for those things which is a bigger cut

03:42

out of people's paychecks than ever before So maybe Grandpa

03:46

Larry is an entirely senile yet after all but he's

03:49

getting there

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