Why should stable prices be a macroeconomic goal?
I mean, why do we even care about inflation?
One reason we care about rising prices lies in the answer to this question: are you beating
inflation, or is inflation beating you?
I.e., is your income keeping pace with rising prices?
There are three possible responses to this question: If your income is rising faster
than inflation, then you're staying ahead of rising prices, and your living standard
rises.
Your money will buy you more goods and services than it did before.
If your income rises as fast as prices, then you’re neither gaining nor losing -- your
living standard stays the same.
If your income rises more slowly than prices, then your income isn't keeping up with inflation,
and your living standards fall.
When your nominal income -- the actual current dollar amount -- is adjusted for any price
changes that have occurred, you get your real income.
This means your real income is your nominal income divided by the CPI (remember, the CPI
reflects what’s happened to overall consumer prices), times 100.
How do I put this formula to use?
Let's go back and take a closer look at the three cases cases.
Case 1) your nominal income rises by more than price level increase.
Last year, you made $50,000.
This year you get a raise, so that you’re making $60,000.
How much of a raise did you get?
Remember, I want to think in terms of percentage change in income, so your income has actually
increased by 20%.
Now, what's happening to prices?
Last year, the CPI was 100; this year, CPI is 110.
This means that prices have gone up by 10%.
Because my income has risen by 20%, while prices have gone up 10%, I know that I must
be better off than before, but let me verify by looking more closely at the effect on my
real income.
Remember that real income is my nominal income, adjusted for any price changes.
In year 1, then, my real income is $50,000, divided by a CPI of 100, times 100, or…
$50,000.
How is this possible?
According to the equation, my real and nominal incomes are the same in year 1!
Well of COURSE they are -- real income is just your nominal income, adjusted for any
price changes.
Since prices haven’t changed (year 1 is the base year), then no adjustments have to
be made.
Well, what happens in year 2?
In year 2, my real income is my new nominal income of $60,000, divided by CPI for year
2, 110, all times 100.
In year 2, then, my real income is $54,545.45.
Not as large of an increase as it looked at first, based on my nominal income, but still
my real income has increased from year 1 to year 2, so I'm better off than I was before.
What about Case 2), where the increase in your nominal income just equals the increasing
prices?
If this happens, I know intuitively that I’m just keeping up with prices.
But let me verify this with an example.
In year 1, you earn $50,000; in year 2, you get a raise so that your income is $55,000.
CPI for year 1 was 100; CPI for year 2 is 110.
We know from previous example that prices have gone up by 10%.
How much did my nominal income rise?
The percentage change in income will be my new salary of $55,000, minus my old salary
of $50,000, all over the original $50,000, times 100, or my nominal income has gone up
by 10%, identical to inflation.
This means that in real terms, I'll be neither better off nor worse off than last year.
Let’s check: I already know my real income for year 1 is $50,000; what about real income
for year 2?
Indeed, real income for year 2, at $50,000, is unchanged from year 1.
My actual living standard will be neither better nor worse than last year.
Lastly, let's examine Case 3): Your nominal income increases by less than the price level
increase.
If this happens, I'll look better off in nominal terms, but actually be worse off in real terms.
Let's take a look: in year 1, your income was $50,000, then you get a raise so that
in year 2, your income is $52,000.
Year one CPI was 100; year 2 CPI is 110.
From previous examples, we know that inflation is 10%, and that real income in year one is
$50,000.
But how much did my nominal income increase, and what happens to my real income?
The percentage change in income is the $2000 raise over the original $50,000, times 100,
or an increase of 4%.
With nominal income up by 4%, but prices up by 10%, what does my real income look like
in year 2?
Even though I have more dollars in my pocket -- $2000 dollars more – the dollars I have
can't buy what I was able to buy last year.
My real income, and therefore my living standard, falls.
NEXT TIME: Unemployment - what does it mean to be unemployed?
TRANSCRIPT00(MACRO) EPISODE 17: REAL INCOME