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In class, we have been using this calculator in order to see the effects of inflation.

https://www.rbnz.govt.nz/monetary-policy/inflation-calculator

I am slightly confused by what is meant by "adjusting for inflation". I read online that this means the effect of inflation is removed. I've also listened to a lot of speeches where people talk about adjusting for inflation.

In the case of this calculator, what does it mean to adjust for inflation? It doesn't mean we remove the effect of inflation, right? And is CPI used to measure the increase in inflation?

And with this calculator, are real or nominal values being used?

(I've been studying economics for a couple of weeks, so sorry for the basic question!)

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Things change in price over time. For example, a movie ticket in 1955 might cost \$.50, and a movie ticket today costs about \$10, 2000% as expensive in 2019 as in 1955. (source)

These are nominal prices. That is, what is the number of dollars I need to pay for a movie ticket?

However, these nominal prices might go up for two reasons. It could be that the item is getting more valuable. Or it could be that the dollar is getting less valuable. In other words:

(1) One is that the relative price of movie tickets might be going up. That is, movie tickets are getting more expensive relative to other goods. For example, imagine a loaf of bread also cost \$.50 in 1955, but cost \$5 today (I'm making these numbers up). In 1955, you'd have to give up one loaf of bread to have enough money to buy a movie ticket. But today, you'd have to give up two loaves of bread to buy a movie ticket. So movie tickets have gotten more expensive relative to bread.

(2) Another reason that movie tickets might get more expensive is because everything gets more expensive together. In other words, the value of the dollar drops. In 1955, you could trade a single dollar for two movie tickets, or for two loaves of bread. Today, you can't trade a single dollar for even one of either. In other words, a dollar today is less valuable than a dollar in 1955.

This second reason, where the value of the dollar drops, is called inflation.

Adjusting for inflation is a process of getting rid of any price changes that happen for reason (2). This is done by calculating (usually using something called the Consumer Price Index) what the prices of things would be if the dollar still had the same value that it did in a different year - if inflation had not occurred (we've adjusted for inflation).

According to the US Inflation Calculator, a single dollar in 1955 is 855.8% as valuable as a single dollar in 2019.

So that 2000% comparison of movie ticket prices we had before? That actually represents that movie tickets are 2000/855.8 = 2.34 (234%) as expensive in 2019 as in 1955 - a 134% increase in relative price. The rest of the nominal price increase is because the dollar itself got weaker.

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  • $\begingroup$ Thanks a lot for the very useful answer. I'm still a bit confused about some things. When you say there is an increase in 234%, is that because of inflation, the ticket getting more valuable, or the dollar changing value? And where did you get the 134 from? Thanks $\endgroup$ – Christopher Uren Aug 5 at 8:38
  • $\begingroup$ The 2000% is because of both inflation/dollar changing value AND the ticket getting more valuable. The 234% is just the ticket getting more valuable. The 234% is saying that the new price is 234% as large as the old price, meaning that it's a 234 - 100 = 134% increase. $\endgroup$ – NickCHK Aug 5 at 18:38
  • $\begingroup$ But isn't that 234 percent increase because of inflation, not value of the ticket, as you're dividing the 2000 by how the dollar changed value? $\endgroup$ – Christopher Uren Aug 6 at 4:38
  • $\begingroup$ The 855.8 is because of the dollar changing value. So when we divide by 855.8, we are taking out the part explained by the dollar changing value (i.e. adjusting for inflation). The part left over (2.34 or 234%) is the part NOT explained by the dollar changing value, i.e. the change in relative price/the ticket getting more valuable. $\endgroup$ – NickCHK Aug 6 at 5:24
  • $\begingroup$ Thanks a lot. When you say the dollar is changing value, is that just because of inflation? $\endgroup$ – Christopher Uren Aug 6 at 5:34
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Adjusting for inflation means just that... How much would this thing that costs X now would have costed back in year Y. Of course, this depends on what good you're talking about. A loaf of bread that costed \$10 in 2000 might cost \$15 now, whereas a t-shirt that costed \$10 in 2000 might cost only \$12 now.

When talking about many goods, this might become problematic, and that's where CPI comes in. CPI is the "price index" for consumption goods. Basically a weighted average of the price of goods consumed by an average household. The number by itself might not mean much, but the growth of CPI ("inflation") says how much the price of an average basket of goods has increased.

When you don't adjust for inflation, you're talking about the nominal value. When you adjust for inflation, you're using the "real" values.

Hope this helps!


Edit: Maybe another example might help. Your salary is \$100 ten years ago and you can buy one basket of apples with that. Now your salary is $200. Can you buy two baskets with your current salary? Likely not, because the price of goods would have increased due to inflation.

Let's say the price of apples increased by 20% over that period, to see how much your salary has actually increased (hence the "real" increase) you need to "remove the effect of inflation" from your salary ("deflate" it) by 20%.

A basket of apples used to cost \$100 ten years ago. Now it costs $120. So with your current salary, you can buy only 200/120 = 1.67 baskets. This means the "real" increase in your salary (i.e. adjusted for inflation) is only 67%.

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  • $\begingroup$ Thanks a lot. I'm still a bit confused about what is meant by removing the effect of inflation (adjusting). When you adjust for inflation when comparing price increases, does that mean you remove the affect of inflation $\endgroup$ – Christopher Uren Jul 4 at 7:44
  • $\begingroup$ Thanks a lot. So for your real income, has it gone from 100 to 167, but nominal from a hundred to two hundred? $\endgroup$ – Christopher Uren Jul 5 at 11:44
  • $\begingroup$ That's correct. $\endgroup$ – Art Jul 8 at 5:26

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