QCC – Fall, 2024 Prof.

Ken Friedman
ECON 215 – Macroeconomics kfriedman@qcc.mass.edu

Lecture Notes for Chapter 7 – Real vs. Actual Prices and Wages

Price Inflation and Money Illusion

In economics we often prefer to deal with real magnitudes such as the actual
quantities of goods and services that money can buy. However, we must often
instead work with monetary values such as the actual prices for products.
These leads to the following value definitions:

NOMINAL = this is the ACTUAL and CURRENT $ price for some product,
the wage for some occupation or the interest rate for credit

REAL = INFLATION-ADJUSTED values that are meant to both reflect and

“correct” for the impact of price change through time
Strangely enough, what economists call “real” values are not real at all!
Normally, we label as “real” what we actually see in the “real” world”. However,
in economics, these are the NOMINAL values. What economics calls real values
are artificial and synthetic numbers that are specifically designed to adjust for
price inflation but nonetheless serve to accurately measure quantity values that
we cannot precisely observe.

Price Inflation and Purchasing “Power”

Here is the big question: what can money buy? We call this the purchasing
power of money. How much “power” a sum of money has will depend on both
what this sum of money is AND what it costs – the prices – to buy valuable items
with this money. The impact of price inflation can become highly deceiving
when long intervals of time are involved as price changes accumulate in a
compounding manner. Thus, some 3% per year may not seem like much, but
across 30 years it can induce a major discrepancy between nominal and real
values. An item that costs $412 would come to be priced at $1,000. We are
now going to explore these inflationary impacts. In each case, we start with
actual nominal price and wage values. We then utilize CPI values to derive real
“price-equivalent” values and then determine the change in pg. 2
the real price of the product or wage.

Solved Problem #1: Product Prices – Cameras

Consider a thirty year time interval and note the following values for the CPI and
for the price of a particular camera:

Consumer Price Index in 2002 = 180.0

Consumer Price Index in 2022 = 291.6

The price for a top-end camera in 2002 = $1,000

The price for a top-end camera in 2022 = $1,400

Clearly, the price of the camera went up across this interval, but how can we make
economic sense of this increase in the nominal or actual $ price? More precisely, we
want to ask this question – did the price of the camera in real terms increase or not?
We address this question by comparing the change in the price of the camera to the
change in the average of all prices for all products – which, of course, is summarized
in the values for the CPI. We apply the following assessment rules:

(1) the price of a product in real terms has risen through time if its:
actual or nominal price has increased by more than the average for all prices (CPI)
(2) the price of a product in real terms has fallen through time if its:
actual or nominal price has increased less than the average for all prices(CPI)

OK, let’s now proceed step-by-step:

Part I: Calculate the % change in the price of the camera:

Step I: Take the price difference:

Actual Price in 2022 – Actual Price in 2002
= $1,400 – $1,000 = +$400
Step II: Divide the price change by the starting price: pg. 3
+ $ 400 $ 1,400
$ 1,000
= 0.40 Note: { $ 1,000 – 1 } = 1.40 – 1 = 0.40

Step III: Multiply this number by 100%: 0.40 * 100% = 40%

Part II: Calculate the percent change in the consumer price index:
Step I: Take the difference in the two CPI values:
CPI in 2022 – CPI in 2002 = 291.6 – 180 = +111.6
Step II: Divide the increase in the CPI by its starting value:
+ 111.6 291.6
180 = 0.62 Note: { 180 -1} = 1.62 – 1 = 0.62
Step III: Multiply by 100%: 0.62*100% = 62%

Part III: What happened to the “real” price of the camera between
2002 and 2022?
Answer: the real price went down as:
% change in actual price = 40% < % rate of general price inflation = 62%

Conclusion: Yes, the price of the camera clearly went up. But the prices of most
other goods went up as well and even by a greater amount. Moreover, recall the
fundamental circular flow of funds framework for national production and income.
If the prices consumer pay went up by 62% then so did expenditures on all goods
and services. But this implies that national income also went up by 62% as every
dollar spent on goods and services flows as income to households collectively. Thus,
with 62% more money on hand to spend then the financial burden of buying a camera
with an increase of 40% in its price has in fact gone down!

Simulated Values and Real “Price Equivalents”

We now want to explore the nature of the product price change further by simulating
values known as real “price equivalents”. The essential idea is this – we have two
actual or nominal $-dollar prices at two points in time. For each one, we can
determine the amount of money at the other point in time that would have the same
purchasing power as each nominal price that was current at its own point in time.
Note that we carry this out in two directions. First, we start with the initial nominal
price (say for the year 2002) and advance it through time to the later date (the year
2022). Then, we reverse course by starting with the nominal price in 2022 and shift
back in time to the starting year (2002).
The underlying assumption with this procedure is that each nominal price
will change at the same %-rate as the rate of general price inflation.

From the Past to the Present pg. 4

The formula for finding the current year real equivalent of a past nominal price is:
Real Price Equivalent in Later Year
CPI ∈ Later Year
= Actual Price in Earlier Year * CPI ∈Earlier Year

CPI ∈2022
Real Price Equivalent in 2022 = Actual Price in 2002 * { CPI ∈2002 }
291.6
= $1,000 * ( 180 ) = $1,000 * 1.62 = $ 1,620

We can understand this through the notion of opportunity cost.

OPPORTUNITY COST: CAMERA VS. ALL OTHER GOODS
What IF the PRICE of the CAMERA ALSO ROSE to $1,620 (+62%)?
THEN: the trade off between all other goods and the new camera would
be the SAME for both years

Interpretation: $1,620 in the year 2022 has the same purchasing power – and can
buy the same bundle of products – as could $1,000 in year 2002. Thus:
{ $1,620 in 2022 } is equivalent in real terms to { $1,000 in 2002 }
Thus, any diversified bundle of goods that cost $1,000 in 2002 would then cost
$1,620 in the later year – 2022. You would then need to have $1,620 in year 2022
to buy the same bundle of items that you could buy with $1,000 in year 2002.

$1,000 → $ 1,620 > $1,400 ; in 2022 : actual < simulated pg. 5

The actual price for the camera in the later year (=$1,400) is less than the
simulated value ( = $1,620) that matches the purchasing power of $1,000 in the
beginning year. Thus, the purchasing power of $1,000 needed to buy the camera in
2002 is greater than the purchasing power of the $1,400 needed to buy the camera in
2022. This clearly implies that the real price for the camera has gone down. A
camera buyer gives up clearly less of all other products in 2022 when paying $1,400
for a camera then they would have to “give up” (i.e. not buy) when allocating $1,000
for the camera in 2002.

From Present to the Past

The formula for finding the earlier year real equivalent of a current nominal price is:
Real Price Equivalent in Earlier Year
CPI ∈Earlier Year
= Actual Price in Later Year * CPI ∈ Later Year

CPI ∈2002
Real Price Equivalent in 2002 = Actual Price in 2022 * { CPI ∈2022 }
180
= $1,400 * ( 291.6 ) = $1,400 * 0.6173 = $ 864.20

Interpretation: $1,400 in the year 2022 has the same purchasing power – and can
buy the same bundle of products – as could $864.20 in year 2002. Thus:

{ $1,400 in 2022 } is equivalent in real terms to { $864.20 in 2002 }

$1,400 → $ 864.20 < $1,000 ; in 2002 : actual > simulated

The purchasing power of $1,000 needed to buy the camera in 2002 is greater than
the purchasing power of the $1,400 needed to buy the camera in 2022 because it is
greater than the real equivalent of $1,400 in 2002 (which is $864). This clearly implies
that the real price was higher in 2002 and therefore went down from 2002 to 2022.
Simply combining the results from above gives:

$1,000 → $ 1,620 > $1,400 ; 2022: actual < simulated

$1,400 → $ 864 < $1,000 ; 2002: actual > simulated
Now ask the following: what would the price of the camera in 2022 need to be
in order for its real price to have remained constant across the 20 years?
Answer: the price must rise by the rate of price inflation which is 62%.
This constant real price value would then be: $1,620. However, if the actual
$ price rose to only $1,400 then the actual price has declined in real terms.

2002 Price 2022 Values

$1,000 * 1.62 ( + 62% ) → $1,620 - real price constant
$1,000 * 1.40 ( + 40% ) → $1,400 - real price decreased

Solved Problem #2: Wages – Carpenters and Cooks pg. 6

As before, the data for the CPI will be:

Consumer Price Index in 2002 = 180.0

Consumer Price Index in 2022 = 291.6

Now consider the following earnings data for this occupation:

A restaurant cook earned $20 per hour in 2002
A restaurant cook earned $28 per hour in 2022

Question: did the cook’s wage increase in real terms across this interval?

Part I: Calculate the % change in the wage for cooks?

Step I: Take the wage difference:
Actual Wage in 2022 – Actual Wage in 2002
= $28 per hour – $20 per hour = +$8 per hour
Step II: Divide the wage change by the starting year wage:
+$ 8 $ 28
$ 20
= 0.40 Note: { $ 20
- 1 } = 1.40 – 1 = 0.40

Step III: Multiply this number by 100%: 0.40 * 100% = +40%

Part II: Calculate the percent change in the consumer price index:
This has already been done. Answer: %∆CPI = +62%

Part III: What happened to the “real” wage for cooks between 2002 and
2022?
Answer: the real wage went down as:
% change in actual wage = 40% <
% rate of general price inflation = 62%

Simulated Values and Real “Price Equivalents”

We now want to explore the nature of the wage change further by simulating values
known as real “wage equivalents”. The essential idea is this – we have two actual or
nominal $-dollar wages at two points in time. For each one, we can determine the
amount of money at the other point in time that would have the same purchasing
power as each nominal wage that was current at its own point in time. Note that we
carry this out in two directions. First, we start with the initial nominal wage (say for
the year 2002) and advance it through time to the later date (the year 2022). Then,
we reverse course by starting with the nominal wage in 2022 and shift back in time to
the starting year (2002). The underlying assumption with this procedure is that each
nominal wage will increase at the same %-rate as the rate of general price inflation.
The formula for finding the current year real equivalent of a past nominal wage is:

Real Wage in Later Year pg. 7

CPI ∈ Later Year
= Actual Wage in Earlier Year * CPI ∈Earlier Year

CPI ∈2022
Real Wage Equivalent in 2022 = Actual Wage in 2002 * { CPI ∈2002 }
291.6
= $20 * ( 180 ) = $20 * 1.62 = $ 32.40

Interpretation: $32.40 in the year 2022 has the same purchasing power – and can
buy the same bundle of products – as could $20 in year 2002. Thus:
{ $32.40 in 2022 } is equivalent in real terms to { $20 in 2002 }

$20 → $ 32.40 > $28 ; in 2022 : actual < simulated

Interpretation: A wage of $32.40 in 2022 provides the same purchasing power for all
goods as did $20 in 2002. But the actual wage went up to $28 – a clearly lower value
and provides for reduced purchasing “power” Thus, the “real” wage went down. In
similar words, in 2022, the actual wage of $28 clearly falls below the value ($32.40)
that provides the same purchasing power as the wage of $20 did in 2002. This clearly
implies that the real wage has gone down.

Now Reverse Time Direction

The formula for finding the earlier year real equivalent of a current nominal wage is:

Real Wage Equivalent in Earlier Year

CPI ∈Earlier Year
= Actual Wage in Later Year * CPI ∈ Later Year

CPI ∈2002
Real Wage Equivalent in 2002 = Actual Wage in 2022 * { CPI ∈2022 }
180
= $28 * ( 291.6 ) = $28 * 0.6173 = $ 17.28 < $20 pg. 8

Interpretation: $28 in the year 2022 has the same purchasing power – and can buy
the same bundle of products – as could $17.28 in year 2002. Thus:

{ $28 in 2022 } is equivalent in real terms to { $17.28 in 2002 }

$28 → $ 17.28 < $20 ; in 2002 : actual > simulated

What $28 buys in 2022 would require $17.28 in 2002 but the actual wage in that year
was $20. Thus, the purchasing of the wage is higher in the earlier year – which
implies that is it lower in the later year – 2022.
Combining the results from above gives:

$20 → $ 32.40 > $28 ; 2022: actual < simulated

$28 → $ 17.28 < $20 ; 2002: actual > simulated
These values confirm the earlier conclusion when 62% was compared to 40%. In
order to compare $20 to $28 we first determine the simulated wage in the year 2022
that would have the same purchasing power as $20 did in 2002. That value is $32.40.
Since this is more than the $28 that a cook actually gets in 2022 we can conclude
that the real wage is lower in 2022.

The same finding emerges from the reverse time perspective. A wage of $28 in 2022
has the same purchasing power as $17.28 in year 2002. Yet, the actual wage in 2002
is a higher value of $20 – implying that the real wage was higher in that year.
This implies that the real wage was lower in the later year and decreased through
time.
We can also ask this question: if a cook was paid $20 per hour in 2002, then how
much would his wage need to be for the real wage to be constant. Answer: the
real wage is constant when it rises through time at the same overall rate as general
price inflation. Since this value is 62%, the constant real wage is $32.40.

2002 Wage 2022 Values

$20 * 1.62 ( + 62% ) → $32.40 - real wage constant
$20 * 1.40 ( + 40% ) → $28 - real wage decreased