Real v. Nominal Wages
Categories: Econ
Old Grandpa Larry has been retired for awhile, 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 is so expensive nowadays!"
Oh, Grandpa. There he goes again, being either sarcastic...or totally not getting that inflation is a thing.
Inflation is the reason prices (and wages, or "nominal wages" to be precise) rise. Your nominal wage is the actual dollar amount on your paycheck, and on grandpa's...when he had one. For you, maybe it's $3,000 a month. For grandpa, it was $3,000...for the whole year.
So Grandpa's not exactly wrong: everything was cheaper back in the day, nominally. 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 he's only thinking of prices rising, not income. If prices rise, but buying-power also rises, then things aren't necessarily 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.
The real 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 Grandpa's, your real wage rate might be pretty similar to what his was in the '50s. Real wage rates allow us to compare the amount of buying power different people have (or 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 "millionaire" in nominal terms 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 or under your mattress. You're much better off keeping your money somewhere where it can gain a little interest, ideally enough to keep up with inflation, which is around 2% a year.
Think about it this way: if Grandpa Larry put a five-dollar bill in his sock drawer in the '50s, that five dollars was worth 20 burgers at the time: 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 one. All that inflation over all of those years eroded the burger-buying value of that five-dollar bill from 20 burgers...down to a single patty.
If you want to keep your buying-power up, the money you have lying around needs to earn around 2% interest a year. If your nominal savings keeps up with inflation, your real savings will retain its real buying power. If Grandpa Larry put that five dollars in a bank account that yielded 2%, he'd be able to buy a lot more with it than just one burger today.
Although...he's not totally wrong about burgers getting more expensive. If he had put that five dollars in a bank account 70 years ago and it grew at 2% a year, that five dollars would now be twenty dollars. Which means it grew 300%. The price of burgers, though, rose from a quarter to five dollars in the same time, which comes out to, uh…1,900%.
While his five dollars was keeping up with inflation, it wasn't growing as fast as the cost of burgers. So the real price of burgers actually did go up. The Consumer Price Index helps us see real price changes like these. For instance, the real prices of college and healthcare have risen by a substantial amount.
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 before. Maybe Grandpa Larry isn’t entirely senile yet after all.
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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