Economists use Consumer Price Index [CPI] to estimate real wages and costs from nominal wages and costs.

Computation of CPI An army of economists gathers prices on a standard “market basket” of goods at fixed time periods (month, year)

Computation of CPI An army of economists gathers prices on a standard “market basket” of goods at fixed time periods (month, year). The prices of the baskets is compared.

Computation of CPI An army of economists gathers prices on a standard “market basket” of goods at fixed time periods (month, year). The prices of the baskets is compared. The prices are converted to index numbers.

The CPI can be used to adjust economic data to remove the effect of changing underlying prices.

Suppose that CPI for three years is as follows: Year 1 50 Year 2100 Year 3200

Year 1 CPI= 50 Year 2CPI= 100 Year 3CPI= 200 That is, things cost twice as much, on average, in Year 2 (Y2) as in Year 1 (Y1). So, $1.00 could buy twice as much as in Year 1 (Y1) as in Year 2 (Y2). So, the value of the Y1 dollar is twice that of the Y2 dollar

Relative values can be computed using this formula: CPI of base year / CPI of object year * 100 (Object year is the year being compared to the base year)

Let’s refer to the formula CPI of base year / CPI of object year as a formula for a conversion factor

Conversion factor = CPI of base year / CPI of object year

Use the conversion factor to adjust the prices: Price * conversion factor = adjusted price

Using previous terminology: Nominal price * conversion factor = real price (relative to base year)

Combining the formula for adjusted price with that for the conversion factor: Nominal price * (CPI base year / CPI object year) = real price

Additional terminology: Current values (prices, wages, etc.) are prices (nominal values) at the value of the currency at that time Constant values (prices, etc.) are prices in real values, i.e., as if the currency had the value of the base year.

Problem: In 1930, Babe Ruth earned his maximum salary: $80,000. How does this compare with today’s salaries?

2007 average salary: $2,944,556 Highest paid player: Alex $23,428,571

What would the average salary and A-Rod’s salary have been in constant (1930) dollars? What would Babe Ruth’s salary have been in constant (2006) dollars?

Babe Ruth: $80, average: $2,944,556 Alex Rodriguez: $23,428,571