When using any variables measured in terms of dollars such as income, earnings, sales, profit, GNP, care must be taken when interpreting changes in these variables over time. To avoid, or more accurately, to correct for the distortion caused by rising prices in a dollar denominated variable, economists construct a new variable known as the real, constant dollar, or inflation-adjusted variable. In your economics courses you will most likely refer to the variables as real variables, while in any government data sources you will find references to constant dollar variables.
Regardless of what you call it, the concept is straight forward enough. We want a measure of wages that will indicate no change in wages if both wages and prices double, and a doubling of wages if wages double and the price level remains unchanged. To construct such a measure we need to first decide on what measure of prices to use. In most instances the Consumer Price Index (CPI ) is used as a measure for the price level. The CPI, published monthly by the Bureau of Labor Statistics, is simply a weighted average of the prices of goods and services that households purchase. If you tend to spend considerably more money on food than movies, you will see
your cost of living decline more as a result of a 10 percent increase in the price of food than a 10 percent increase in the price of movies. For a brush up on the CPI you might want to check out a simple example .
Once you have the price data, the procedure for adjusting the nominal quantity is quite simple, but extremely useful. In the following example nominal (actual) wage data is corrected to create real (inflation adjusted) wage data. The formula for the adjustment is:
R = N/PI *100
R = real value (constant dollar)
N = nominal value (current dollar)
And the adjustment does matter. To see how much, check out the analysis of the financial situation at URI. Here we will return to our Slippery Slope example to examine the impact of the adjustment. To incorporate into the analysis any effect of price inflation, we must start with getting information on the price level. In the third column information on the price level has been added. The Price Index column is the Consumer Price Index (CPI) that you hear people talk about every month and that you can get directly from the Bureau of Labor Statistics site or from the Economic Report of the President tables .