Adjusting Wages for the Inflation Rate

Adjusting Wages for the Inflation Rate
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  • 0:04 Real and Nominal Wages
  • 1:19 Comparing Wages in Two Years
  • 2:58 Comparing Wage Rates…
  • 5:37 Comparing Wages in…
  • 7:57 Comparing Wages in a…
  • 9:09 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

Have you ever heard your parents complain that a dollar doesn't go as far as it used to? In this practical lesson, learn how to calculate the real wage by adjusting the nominal wage to account for changes in the price level within the economy.

Real and Nominal Wages

Inflation isn't just another government statistic measuring the economy. It's one of the biggest problems that we as citizens face because it affects the value of our money, which affects our standard of living or what we can afford. It affects tens of millions of people throughout the nation. When prices continue rising, purchasing power declines; a dollar will buy less and less each year. That's why it's important to you and me, and that's why keeping it low is one of the biggest priorities of the central bank.

When we want to compare wages from one year to the next, we have to consider inflation, and that's why we use the real wage. The real wage is the nominal wage in a given year in terms of the price level in a previous year. The nominal wage is simply the wage in basic dollar terms.

The real wage removes the effect of rising prices, and shows us what the wage is really worth in terms of purchasing goods and services. It helps us compare wages in different years as well as wages in different cities with different costs of living. Let's go through several examples and learn how to adjust wages for inflation.

Comparing Wages in Two Years

This formula can be used to calculate wage purchasing power.
Formula Comparing Wages Two Years

We'll start with Bob, who owns a well-known lawn service company. Bob's income is affected by inflation.

We measure the rate of inflation using the Consumer Price Index, which is reported by the Bureau of Labor Statistics, part of the federal government. Last year the Consumer Price Index, or (CPI) for short, was 130 and Bob's household earned $70,000. However, this year the CPI is 138, which means that inflation was eight percent higher than last year. What we want to know (and surely Bob is as curious as we are) is what would Bob's household need to earn in order to have the same purchasing power as last year?

Well, the following formula will help us out: The nominal wage in year one divided by the CPI in year one multiplied by the CPI in year two. Let's plug in the numbers we were given and see what we get: ($70,000 / 130) x 138 = $74,308. What does that mean? That means Bob would've had to earn $74,308 to have the same purchasing power as $70,000 last year.

Comparing Wage Rates in Two Years

Now, let's look at a similar scenario, but this time using a wage rate instead of a wage. Last year, Lydia, an assembly-line worker, earned $10 per hour, when the Consumer Price Index (or CPI) was 100. This year, the same worker earned $12 per hour, while the CPI has increased to 105. What we want to know is: did Lydia's real wage increase, decrease, or stay the same?

For this question, let's use the following formula: real wage in a given year is equal to nominal wage in that year divided by the CPI in that year all multiplied by 100.

We're going to adjust each year's nominal wage rate by that year's CPI, then compare the two real wages so we can draw some important conclusions. So here's what we get in this example: the real wage in year one is equal to ($10 / 100) x 100 = $10. The real wage in year two is equal to ($12 / 105) x 100 = $11.43. Now that we've converted the nominal wage rates to real wage rates, we can compare them. In this case, real wages increased from $10 to $11.43.

The formula for converting nominal wages to real wage rates
Converting Nominal to Real Wage Rates

Okay, it's time for another example. In year one, Lydia's nominal wage is $25,000, and the CPI is 100. The following year, the worker's nominal wages stay the same, but the CPI is 105. In order to calculate the worker's real wage in year two, we should adjust the nominal wage in year two by inflation, as follows: ($25,000 / 105) x 100 = $23,809.52. That means Lydia's real wage declined from $25,000 to $23,809.52, even though her actual paychecks (as measured in nominal terms) totaled $25,000 that year.

So when the nominal wage stays exactly the same between two different years, but prices rise, the real wage declines.

Comparing Wages in Multiple Years

Now let's look at wages over a longer time period. Lydia's cousin, Daniel, works as a salesman. Lydia asks her cousin if his wages have increased over the last three years. Daniel answers that his wages have increased by $10,000. Lydia, not fully convinced, does some research on the Consumer Price Index. The following table summarizes Daniel's wages over the last three years, along with the corresponding levels of price. Here you can see the table that shows what the consumer price did, and what Daniel's wages were each year.

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