Real v. Nominal Wages

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.