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What do statements like

Flow variables (such as dividend growth and returns) are deflated using the CPI index.

or

Level variables are deflated using the Producer Price Index (PPI).

mean?

  • What are level varibales?
  • I guess both indices correct for inflation but why would dividend growth/returns need to be adjusted?
  • How does one actually implement this deflation of variables? Is there a time series of the CPI and PPI available only and one simply has to multiply a particular variable with the index?
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Level (also called stock) variable, is a variable that measures something at a given point of time. For example, measuring GDP in 2017 would be a level (stock) variable.

Flow variable is a variable that measures the rate of change in the stock over time. For example, if GDP growth (which measures flow of GDP) was $10\%$ in 2017 that means that the level/stock of GDP increased by $10\%$.

Wikipedia actually has surprisingly excellent explanation on differences between level/stock and flow/growth variables that you can read here (see the general use part).

There is no reason why you would always want to apply CPI to flow variables and PPI to level variables. This must be something that is specific to the research you are reading and there must be some other reason behind it.

If you want to deflate a level variable using some particular deflator you can use the following formula:

$$Real X = \frac{Nominal X}{deflator/100}$$

If you want to adjust flow variable then you can first calculate the change in deflator and subtract that change from the flow variable that is:

$$ g_r = g_n - \pi$$

where $g$ is the real ($r$)/nominal ($n$) flow/growth rate respectively and $\pi$ inflation rate which is the change in deflator. Also the above is a first order approximation. The exact formula is given by $1-g_r = \frac{1+ g_n}{1+\pi}$ but this exact formula is not often used.

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  • $\begingroup$ Thanks very much for your thorough answer! Could you think of any reason why to adjust returns/growth rates (either by PPI or CPI)? I understand that level variables like prices need to be adjusted (inflation), but I don’t see the benefit of doing the same with flow variables? $\endgroup$ – Alex Jul 16 at 0:05
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    $\begingroup$ @Alex because if you use unadjusted flow variable say GDP growth - you have no idea how much of that growth is due to real increase in production and how much due to inflation. For example nominal GDP g could be 5% while inflation could be 10% implying that real economy actually is doing worse by 5% or if inflation would be 1% it would be doing better in real terms by 4%. In econ we usually care about real growth/flow because that is what usually matters more $\endgroup$ – 1muflon1 Jul 16 at 0:08
  • $\begingroup$ Makes sense, thank you. I’m just surprised because I read rarely finance papers which deflate flow variables. I guess it has negligible effect on monthly data? Last question: do you know a source from where I could obtain the CPI and PPI data? $\endgroup$ – Alex Jul 16 at 7:32
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    $\begingroup$ @Alex that might be because they already calculate the flow variable from a real variable. There might also be situations where it’s maybe not necessary but normally even monthly data would be deflated. The source will depend on a country. For USA Fred database has a lot of various deflators for EU eurostat would be the place to look fred.stlouisfed.org/categories/21 $\endgroup$ – 1muflon1 Jul 16 at 11:28
  • $\begingroup$ Thank you so much for your answer and comments! Very valuable! $\endgroup$ – Alex Jul 16 at 11:42

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