The data on nominal and real GDP in Argentina illustrate the dangers of looking at nominal rather than real variables. Had you looked at only nominal GDP, you would have concluded that the Argentine economy had been growing between 1993 and 2002, when it was actually stagnating.
But many economic statistics—not only nominal GDP—are typically quoted in terms of dollars (pesos, euros, ringgit, or whatever the currency of the country is). To make sense of such statistics, we must understand whether changes in these statistics represent real changes in the economy or are simply a result of inflation.
Toolkit: Section 16.5 "Correcting for Inflation"
If you have some data expressed in nominal terms (for example, in dollars) and you want to covert them to real terms, use the following steps.
- Select your deflator. In most cases, the CPI is the best deflator to use.
- Select your base year. Find the value of the index in that base year.
- For all years (including the base year), divide the value of the index in that year by the value in the base year. (This means that the value for the base year is 1.)
- For each year, divide the value in the nominal data series by the number you calculated in Step 3. This gives you the value in base year dollars.
Here is an example of how to correct for inflation. Suppose that a sales manager wants to evaluate her company’s sales performance between 2000 and 2005. She gathers the sales data shown in Table 3.5 Sales, 2000–2005.
|
Year |
Sales (Millions of Dollars) |
|
2000 |
21.0 |
|
2001 |
22.3 |
|
2002 |
22.9 |
|
2003 |
23.7 |
|
2004 |
24.1 |
|
2005 |
24.7 |
At first glance, these numbers look reasonably encouraging. Sales have grown every year between 2000 and 2005. But then she remembers that these data are in nominal terms, and there was also some inflation over this time period. So she decides to correct for inflation. She first goes to the Economic Report of the President and downloads the data in Table 3.6 Consumer Price Index, 2000–2005. 1She decides to use 2000 as the base year—she wants to measure sales in year 2000 dollars. So there are two steps to her calculations, as shown in Table 3.7 Sales Data Corrected for Inflation, 2000–2005. First, she takes the CPI series and divides every term by the 2000 value (that is, 172.2). This gives the third column of Table 3.7 Sales Data Corrected for Inflation, 2000–2005, labeled “Price Index.” Then she divides each of the sales figures by the corresponding price index to obtain the real (that is, corrected for inflation) value of sales. These are given in the final column of the table.
|
Year |
CPI |
|
2000 |
172.2 |
|
2001 |
177.1 |
|
2002 |
179.9 |
|
2003 |
184.0 |
|
2004 |
188.9 |
|
2005 |
195.3 |
|
Year |
CPI |
Price Index |
Sales |
Real Sales |
|
(Base=2000) |
(Millions of Dollars) |
(Millions of Year 2000 Dollars) |
||
|
2000 |
172.2 |
1.00 |
21.0 |
21.0 |
|
2001 |
177.1 |
1.03 |
22.3 |
21.7 |
|
2002 |
179.9 |
1.04 |
22.9 |
21.9 |
|
2003 |
184.0 |
1.06 |
23.7 |
22.2 |
|
2004 |
188.9 |
1.10 |
24.1 |
22.0 |
|
2005 |
195.3 |
1.13 |
24.7 |
21.8 |
We can see that the sales data are much less rosy after we account for inflation. Sales were increasing between 2000 and 2003 in real terms, but real sales decreased in 2004 and 2005. Had she just looked at the dollar measure of sales, she would have completely missed the fact that the business had experienced a downturn in the last two years.
Economic statistics reported in the news or used by businesspeople are very often given in nominal rather than real terms. Perhaps the single most important piece of “economic literacy” that you can learn is that you should always correct for inflation. Likewise, you should be on your guard for misleading statistics that fail to make this correction. Here is an example from an article that appeared in the Washington Post. “The Clinton recovery has been far less egalitarian than the much-criticized Reagan ‘era of greed.’ Between 1990 and 1995, the [real average] family income actually declined slightly while the number of people with a net worth over $1 million more than doubled.” 2
Can you see why this sentence is so misleading? It mixes together a real measure and a nominal measure in the same sentence. Real family income—that is, family income corrected for inflation—declined in the first half of the 1990s. But the number of millionaires is a nominal measure. In a time of inflation, we would expect to have more millionaires, even if people are not really getting any richer.
KEY TAKEAWAY
- A price index is created by calculating the cost of purchasing a fixed basket of goods in different years.
- The CPI is a price index for goods and services, including imported goods, consumed by households, while the GDP deflator is based on all the goods and services that compose GDP.
- Calculating a price index is difficult due to the introduction of new products, quality changes, and changes in purchasing patterns.
Checking Your Understanding
1. The BLS has an inflation calculator on its website (http://data.bls.gov/cgi-bin/cpicalc.pl), which is shown in Figure 3.10 "BLS Inflation Calculator".
2. In Table 3.7 Sales Data Corrected for Inflation, 2000–2005, calculate the inflation rate (that is, the percentage change in the price index) and the growth rate of sales in each year. What is the relationship between these two variables (a) when real sales are increasing and (b) when real sales are decreasing?
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