When using any variables measured in terms of dollars such as income, earnings, sales, profit, GNP, care must be taken when interpreting changes in these variables over time. To avoid, or more accurately, to correct for the distortion caused by rising prices in a dollar denominated variable, economists construct a new variable known as the real, constant dollar, or inflation-adjusted variable. In your economics courses you will most likely refer to the variables as real variables, while in any government data sources you will find references to constant dollar variables.
Regardless of what you call it, the concept is straight forward enough. We want a measure of wages that will indicate no change in wages if both wages and prices double, and a doubling of wages if wages double and the price level remains unchanged. To construct such a measure we need to first decide on what measure of prices to use. In most instances the Consumer Price Index (CPI) is used as a measure for the price level. The CPI, published monthly by the Bureau of Labor Statistics, is simply a weighted average of the prices of goods and services that households purchase. If you tend to spend considerably more money on food than movies, you will see your cost of living decline more as a result of a 10 percent increase in the price of food than a 10 percent increase in the price of movies. For a brush up on the CPI you might want to check out a simple example.
Once you have the price data, the procedure for adjusting the nominal quantity is quite simple, but extremely useful. In the following example nominal (actual) wage data is corrected to create real (inflation adjusted) wage data. The formula for the adjustment is:
And the adjustment does matter. To see how much, check out the analysis of the financial situation at URI. Here we will return to our Slippery Slope example to examine the impact of the adjustment. To incorporate into the analysis any effect of price inflation, we must start with getting information on the price level. In the third column information on the price level has been added. The Price Index column is the Consumer Price Index (CPI) that you hear people talk about every month and that you can get directly from the Bureau of Labor Statistics site or from the Economic Report of the President tables.R = real value (constant dollar)
N = nominal value (current dollar)
PI = price index
|Revenue||Price Index||Real Revenue|
This diagram also helps explain the proliferation of reports indicating the plight of Generation X, those who are moving into the labor force in the early 1990's. The forecasts that this generation may be the first to not achieve a standard of living higher than that of their parents is simply the result of an extrapolation of existing trends.
A similar problem exists when we examine interest rates or other rate of return variables. Consider the position of a money lender who must determine the appropriate interest rate to charge. Certainly one of the considerations will be the rate of inflation, the rate of increase in the price level (CPI). If the inflation rate is 6 percent, a lender must receive 6 percent interest just to maintain the money's buying power. Stated somewhat differently, if the cost of living increases 6 percent this year, then what you can buy this year for $100 will cost $106 next year. In this situation a lender must charge 6 percent to stay even - so as to receive the $106 in one year. If on the other hand, the lender wanted a 2 percent return on money, then the interest rate would need to be 8 percent with 6 percent simply accounting for inflation.
The realization that inflation rates are a common denominator in interest rates has prompted economists to develop a concept called 'real interest rates'. The unobserved 'real' rate which is what 'really' matters to decision makers, is defined as the actual rates minus the expected inflation rate. The relationships between real and nominal rates is captured in the equations where the expected inflation rate equals the actual rate:
rn = actual interest rate (what you see in the news)As with wage earnings, there is a significant difference between the movement in real and nominal interest rates. In the 1980s for example, nominal short term rates on government securities fell sharply from 11.5 percent in 1980 to 6 percent in 1986 before rising to 7.5 percent in 1990. Real interest rates, meanwhile, moved in the opposite direction. After actually being negative in 1980, real rates rose to 4.1 percent in 1986 and then fell back towards 2 percent in 1990.
rr = real interest rate i = inflation rate