Adjusting historical amounts for inflation requires the use of inflation index values published by statistical collection agencies such as the Office of National Statistics.
The formula to adjust a historical nominal amount for inflation is:
[Real Amount] = [Nominal Amount] * ( [Later Period Index Value] / [Earlier Period Index Value] )
There are several ways of describing the value of an item:
- Nominal Amount – the amount that was actually paid for an item when it was purchased.
- Real Amount – the inflation-adjusted amount paid for an item, what it would cost using today’s money.
What is inflation?
Inflation represents the reduction over time of the purchasing power of a unit of currency.
In other words, a dollar from the past used to purchase a larger quantity of goods than a dollar from today.
Why adjust for inflation?
People are prone to remembering prices in the past being lower than they are today. Adjusting prices for inflation allows us to compare amounts across different time periods using a common basis. Only then can we assess whether things have gotten more (or less) expensive.
The battery box that powers my kid’s Lego train recently died. Was the replacement part more or less expensive today than it had been 40 years ago?
In 1978 a Lego model train battery box cost £1.35.
In 2018 the equivalent part cost £11.99.
I looked up the Office of National Statistic’s Retail Price Index values for 1978 and 2016 (the most recently published figure available at the time of writing). I then plugged those values into the inflation adjustment formula.
Real Amount = [£1.35] * ( 258.56 / 43.11 ) = £8.09
Today’s price of £11.99 is greater than the inflation-adjusted historical amount of £8.09.
Therefore we can conclude that the price of this item has increased at a faster rate than inflation.
Real economists adjust for inflation
Any good comparative analysis of financial values across time periods will always adjust values for inflation. Failing to do so distorts the facts and tells an incorrect story.
Consider the two charts below. The Department of Education recently issued a report highlighting that university graduates typically earn more than non-graduates. On the left is a chart displaying the median earnings in nominal amounts. On the right is a chart displaying those same median earnings, but this time as inflation-adjusted real amounts.
Both charts highlight the earnings difference. The trend lines on both charts finish at identical points.
Now compare the direction of the lines between the charts.
The nominal values chart happily shows earnings increase over time. It tells the story that investing in yourself by completing university will result in higher earnings that increase over time.
The real values chart tells a very different story. What jumps out is the fact that inflation-adjusted earnings have been falling over the last 10 years, at a faster rate for graduates than non-graduates!
While it is still true that graduates earn higher incomes than non-graduates, the context for the invest in yourself decision has changed. Would you be as likely to take on lots of student debt if you knew your standard of living (funded by real wages) would fall rather than rise?
Whenever you see period-on-period comparisons or time series trends presented, always “trust, but verify” that the figures being discussed are using real and not nominal values. If they do not then critically assess the conclusions being drawn.
- Validate your trends, forecasts, and projections to ensure you are accounting for inflation.
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