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

Finance: What is Inflation and How Does ...46 Views

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Finance allah shmoop shmoop what is inflation and how does

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it work This is inflation and this is inflation and

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this is infiltration but really isn't relevant So get that

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out of here okay The kind of inflation were referring

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to is the kind where money gets more prolific so

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that prices that have stayed steady well feel cheaper All

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right now what the fuck does that mean Well when

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economies are good and everyone is working getting paid able

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to save money and buy themselves luxuries like ah waffle

00:36

maker that injects maple syrup directly into the waffle While

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people tend to be willing to pay more to get

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stuff they'll pay two hundred dollars a person for a

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one day pass to disneyland They'll buy a second car

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a flashy one that gets terrible mileage but will impress

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the neighbors They'll buy this thing whatever it is because

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it is heart Why not there's more money to go

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around Products want to increase in price Ah home in

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eighteen eighty and central california might have cost a thousand

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bucks that same home today Well it's been remodeled a

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couple times but it might cost a quarter million dollars

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Or more but annual wage or salary in eighteen eighty

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Might have been two hundred dollars So that house cost

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five years Wages gruel forward to today in an average

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wage is fifty grand And voila Well that home also

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costs about five years Wages was their inflation Oh yeah

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Big time Was there really cost increase in the house

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will know you had to work the same amount in

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eighteen Eighty is he do today to buy the same

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house All right So why do people want inflation Like

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why did money have to go up so much When

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five yearswork buys the same today as it did one

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hundred fifty years ago Psychology mohr is more which means

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better So people simply like having a bigger number Over

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time it comforts them to think that they're actually gaining

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traction in the financial creek in which they are paddling

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Perhaps more importantly governments want inflation Why Because they borrowed

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tons and tons and tons of money But most of

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the money the governments have borrowed is in fixed terms

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or steady interest rate numbers That is the government agrees

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to sell fifty billion dollars worth of debt at two

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And a half percent interest We exist in a given

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time period at a rate of two point five percent

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inflation calculated as the existing costs of a basket of

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stuff that people buy You know like milk paper towels

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a six pack of bundy's dog treats heartburn medication that

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waffle thing And so on Those and many other prices

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air checked in dozens of stores averaged and totaled And

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a gross number comes out each year In this case

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the total basket of goods assessing inflation last year might

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have been well let's say a hundred grand for simplicity's

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sake This year that same total is one hundred two

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thousand five hundred dollars that's How we got that two

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point five percent annual inflation rate Okay so now there's

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a shock to the system A bomb goes off in

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a mini war start The economy booms his government's by

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all kinds of us products In an effort to you

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know kill one another The bomb making factories pay a

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lot of overtime Toe workers who spend more save more

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and inflation starts to happen all of a sudden that

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carton of milk which used to be three boxes now

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four bucks and everything else moves the same direction So

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we go from a steady hundred year average rate of

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about two and a half percent a year to now

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suddenly a seven percent inflationary environment and that last for

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five years before regressing to the mean of two and

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a half percent So we have five years come Found

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it at a four and a half percent increase in

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inflation It quote made money cheaper unquote As for that

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fifty billion bucks the government borrowed it still has to

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pay the two and a half percent of your interest

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on lee now it's relatively way cheaper to pay back

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that loan You can imagine the case that brazil had

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in desperately trying to pay back its loans many times

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in the asked by inflating its currency i eat making

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the federal borrowing rate from its treasury super cheap like

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one percent or less It made borrowing easy for businesses

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and individuals and in the process drove very high inflation

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rate it's almost twenty percent a year on average for

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a sustained period of time This means that the real

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cost of debt drops by about fifty percent every three

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And a half years or so and that the people

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who loaned the brazilians money were very very p oed

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might seem like inflation then it's just a dandy thing

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to have It makes loans cheaper It lets everyone pay

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off their bills quicker easier better The problem is that

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what happens next time A government wants to borrow money

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and they have a track record of letting inflation spiral

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out of control Lenders just go away How deflating hey

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