Correcting Economic Variables for the

Effects of Inflation

1. DOLLAR FIGURES FROM DIFFERENT TIME

• Dollar figures from different times do not represent a valid comparison of
purchasing power
• To compare a dollar figure from the past to a dollar figure today, the older
figure should be inflated using a price index.
• The formula:
 Correcting Economic Variables for the
Effects of Inflation

EXAMPLE
In 1931, the New York Yankees paid famed baseball player Babe Ruth a
salary of $80,000. At the time, this pay was extraordinary, even among
the stars of baseball. In 2015, the average salary earned by major
league baseball players was about $4 million, and Los Angeles Dodgers
pitcher Clayton Kershaw was paid $31 million. The question is, was his
salary of $80,000 in 1931 high or low compared to the salaries of
today’s players? Government statistic shows that consumer price index
is 15.2 for 1931 and 229.5 for 2012.
 Correcting Economic Variables for the
Effects of Inflation

ANSWER
Price Index 1931 = 15.2
Price Index 2012 = 229.5
Salary In 2012 Dollars = Amount in Year 1931 Dollars x Price level 2012
Price level 1931
= $80.000 x 229.5
15.2
= $1.207.894

Babe Ruth’s 1931 salary is equivalent to over $1.2 million in 2012. But it is still
less than median Yankee salary in 2012, which is $4 million and it is only 4%
of his salary. This happened because of the economics growth in 2012 and the
living standard in that time also increase
 Correcting Economic Variables for the
Effects of Inflation

2. INDEXATION
• Price indexes are used to correct for the effects of inflation when comparing
dollar figures from different times.
• When some dollar amount is automatically corrected for changes in the
price level by law or contract, the amount is said to be indexed for inflation.
• For example, many long-term contracts between firms and unions include
partial or complete indexation of the wage to the CPI
 Correcting Economic Variables for the
Effects of Inflation

EXAMPLE
ABC Bank main salary is Rp. 5.000.000, then on 2018, the inflation rate is
4.5%, so the calculation is:

(Main Salary x Inflation Rate in 2012) + Main Salary

= (Rp. 5.000.0000 x 4.5%) + Rp. 5.000.000
= Rp. 5.225.000

So, the new main salary of ABC Bank employee after inflation affect is
Rp.5.225.000
 
 Correcting Economic Variables for the
Effects of Inflation

3. REAL AND NOMINAL INTEREST RATES

• Interest value could changes depends on time.
• To understand how much a person earns in a savings account, we need to
consider both the interest rate and the change in prices.
• There are 2 types of interest rate, which is nominal interest rate and real
interest rate

Real interest rate = Nominal interest rate – Inflation rate

 Correcting Economic Variables for the
Effects of Inflation

Nominal Interest Rate Real Interest Rate

• The interest rate that measures the • The interest rate corrected
change in dollar amounts for inflation

• Tells you how fast the number of • Tells you how fast the
dollars in your bank account purchasing power of your bank
rises over time account rises over time.
 Correcting Economic Variables for the
Effects of Inflation

EXAMPLE
Sally is a movie fan and buys only DVDs. Sally made a deposit of $1000 in the
bank. When Sally made her deposit, a DVD cost $10. Her deposit of $1,000 was
equivalent to 100 DVDs. A year later, after getting her 10 percent interest, she
has $1,100. The amount of DVDs she can buy now depends on the price of the
DVD itself.
 Correcting Economic Variables for the
Effects of Inflation

Price : $10
Amount of DVDs bought : 110
ZERO INFLATION Purchasing power increased by 10%

Price : $11.20
Amount of DVDs bought : 98
Purchasing power decreased by 2%
12% INFLATION

Price : $9.80
Amount of DVDs bought : 112
Purchasing power increased by 12%
2% DEFLATION