17.8 Correcting for Inflation

If you have some data expressed in nominal terms (for example, in dollars), and you want to convert them to real terms, you should use the following four steps.

  1. Select your deflator. In most cases, the Consumer Price Index (CPI) is the best deflator to use. You can find data on the CPI (for the United States) at the Bureau of Labor Statistics website (http://www.bls.gov).
  2. Select your base year. Find the value of the index in that base year.
  3. For all years (including the base year), divide the value of the index in that year by the value in the base year. Notice that the value for the base year is 1.
  4. For each year, divide the value in the nominal data series by the number you calculated in step 3. This gives you the value in “base year dollars.”

Table 17.2 "Correcting Nominal Sales for Inflation" shows an example. We have data on the CPI for three years, as listed in the second column. The price index is created using the year 2000 as a base year, following steps 1–3. Sales measured in millions of dollars are given in the fourth column. To correct for inflation, we divide sales in each year by the value of the price index for that year. The results are shown in the fifth column. Because there was inflation each year (the price index is increasing over time), real sales do not increase as rapidly as nominal sales.

Table 17.2 Correcting Nominal Sales for Inflation

Year CPI Price Index ($2000 Mil.) Sales (Millions) Real Sales ($2,000 Mil.)
2000 172.2 1.0 21.0 21.0
2001 177.1 1.03 22.3 21.7
2002 179.9 1.04 22.9 21.9

This calculation uses the CPI, which is an example of a price index. To see how a price index like the CPI is constructed, consider Table 17.3 "Constructing a Price Index", which shows a very simple economy with three goods: T-shirts, music downloads, and meals. The prices and quantities purchased in the economy in 2007 and 2008 are summarized in the table.

Table 17.3 Constructing a Price Index

Year T-Shirts Music Downloads Meals Cost of 2008 Basket Price Index
Price ($) Quantity Price ($) Quantity Price ($) Quantity ($)
2007 20 10 1 50 25 6 425 1.0
2008 22 12 0.80 60 26 5 442 1.04

To construct a price index, you must decide on a fixed basket of goods. For example, we could use the goods purchased in 2008 (12 T-shirts, 60 downloads, and 5 meals). This fixed basket is then priced in different years. To construct the cost of the 2008 basket at 2008 prices, the product of the price and quantity purchased for each of the three goods in 2008 is added together. The basket costs $442. Then we calculate the cost of the 2008 basket at 2007 prices: that is, we use the prices of each good in 2007 and the quantities purchased in 2008. The sum is $425. The price index is constructed using 2007 as a base year. The value of the price index for 2008 is the cost of the basket in 2008 divided by its cost in the base year, 2007.

When the price index is based on a bundle of goods that represents total output in an economy, it is called the price level. The CPI and the gross domestic product (GDP) deflator are examples of measures of the price level (they differ in terms of exactly which goods are included in the bundle). The growth rate of the price level (its percentage change from one year to the next) is called the inflation rate.

We also correct interest rates for inflation. The interest rates you typically see quoted are in nominal terms: they tell you how many dollars you will have to repay for each dollar you borrow. This is called a nominal interest rate. The real interest rate tells you how much you will get next year, in terms of goods and services, if you give up a unit of goods and services this year. To correct interest rates for inflation, we use the Fisher equation:

real interest rate ≈ nominal interest rate − inflation rate.

Key Insights

  • Divide nominal values by the price index to create real values.
  • Create the price index by calculating the cost of buying a fixed basket in different years.