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|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 1KCSkpWvSml9KZaqTO7TGWsUDpACZIxBoqs9Yw62Klx8 | how-are-incomes-adjusted-for-inflation | article | {
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"text": "Nominal incomes \u2018deflated\u2019 by a price index give us real incomes",
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"text": "An example: Adjusting wages for inflation in the UK",
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"text": "When looking at data on people\u2019s incomes, it\u2019s usually not the quantity of currency that we\u2019re interested in. It\u2019s what this quantity means for their standard of living \u2013 the quantity and quality of the ",
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"text": "To study this, we need to compare people\u2019s incomes with the prices of the goods and services they can buy. These change over time \u2013 the prices on supermarket shelves that you remember from the past are typically not the same as you\u2019ll see today. Adjusting for this is crucial if we want to use income data to understand how living standards are changing around the world.",
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"text": "For this reason, almost all of the income data you\u2019ll find on Our World in Data is adjusted for inflation.",
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"text": "It\u2019s important to note that here we\u2019re referring to both positive and negative inflation. When incomes are adjusted for inflation, they are also at the same time adjusted for the opposite \u2013 ",
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"text": "But how is this adjustment done?",
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"text": "A simple example: adjusting incomes for the price of ",
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"text": "A simple approach would be to adjust incomes for the change in the price of a",
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"text": " product that is commonly purchased \u2013 for example, a loaf of bread. If the price of bread doubles over a period, but your employer still pays you the same income, then you can only buy half as much bread. Your income, adjusted for the inflation of bread prices, has halved.",
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"text": "The chart below shows historical data on the relationship between incomes and the price of another commonly purchased product: books. It looks at this relationship the other way around: it shows how long the average worker had to work to afford one book. We see that the price of a book, relative to incomes, rapidly declined with the invention of the printing press in the 15th century.",
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"text": "This means the reverse is also true: incomes, relative to the price of books, rose dramatically. What was once totally out of reach for all but the richest elite \u2013 to own a book \u2013 became increasingly affordable to the majority. Only by comparing data on incomes to the prices of goods over time can we learn how people\u2019s options and opportunities change.",
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"text": "The Consumer Price Index: a measure of the ",
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"text": "Comparing incomes to the price of only one product has an obvious problem: changes in this price may not be representative of all the other products that consumers buy. Changes in the price of a loaf of bread, or a book, may differ from changes in the prices of medicines, heating, or computers. The price of some of these goods may increase while others decrease.",
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"text": "When adjusting incomes for inflation, statisticians rely on a \u201c",
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"text": " that are representative of the consumption of the average household. Since people buy different things in different countries, these household consumption baskets vary from country to country. The basket is also updated over time, as new technologies emerge making new goods or services available, and as consumption preferences change.",
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"text": "Statisticians monitor the prices of all the products in this basket and calculate a weighted average: when calculating the overall price level, they give more importance to the products that people spend a large share of their income on. This average price level is then expressed relative to the price level in a chosen base year. This is known as the Consumer Price Index (CPI). In the base year, the CPI is equal to 100, and in other years it shows us the price level relative to that year. A CPI of 120 means that prices are 20% higher than in the base year.",
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"text": "The following chart shows CPI data gathered from national statistical offices by the International Monetary Fund. The base year in this case is 2010, so a CPI of 120 means that prices rose by 20% since 2010.",
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"text": " incomes \u2018deflated\u2019 by a price index give us ",
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"text": "The CPI allows us to compare incomes not to the price of one particular good, but to the broader cost of living. By adjusting incomes with the CPI, we learn not about how many books or loaves of bread people can buy, but about their options and opportunities for consumption more generally.",
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"text": "Income data generally arrives to us in what\u2019s called \u2018nominal\u2019 terms: without any adjustment for inflation. If you compare the figure on your paycheck to the figure ten years ago to understand how your income has changed, you are not considering how the price of goods also changed over that time. For this reason, nominal incomes are often referred to as incomes measured in \u2018current prices\u2019.",
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"text": " incomes\u2019 is how researchers and statisticians refer to income data after it has been adjusted for inflation \u2013 or \u2018deflated\u2019, as it is sometimes called. The changes in ",
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"text": " incomes tell us the change in what people can ",
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"text": " afford. This is often referred to as income measured in \u2018constant prices\u2019: it tells us the amount of goods and services a person\u2019s income could have bought if prices had stayed the same as observed in one particular year (the base year of the CPI).",
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"text": "Such an adjustment is crucial for making meaningful comparisons over time. Only ",
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"text": " incomes \u2013 measured in terms of constant prices \u2013 give us an idea about how the prosperity of a population changes.",
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"text": "To provide an example of an inflation adjustment, the chart below shows the evolution of average weekly wages in the United Kingdom. It shows three series:",
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"text": "Between 1750 and 2015, nominal wages in the UK increased from \u00a30.29 to \u00a3492 per week. This is a 1695-fold increase.",
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"text": "But with these higher nominal wages, workers cannot buy 1695 times the value of goods and services, because prices rose considerably over this time too. In this chart, 2015 is the base year used for the consumer price index: in 2015, it has a value of 100. In 1750 it has a value of 0.66. The ratio between these two observations \u2013 100 divided by 0.66 \u2013 is 152, and this tells us that the average prices that consumers face increased 152-fold over these 265 years.",
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"text": "To calculate the real wage increase, we need to look at the nominal wage increase compared to the increase in prices. The third line shows real average wages: nominal wages divided by the consumer price index, expressed as a fraction. In 2015, real and nominal wages are the same. In the late 1980s, when prices were around half their 2015 level, real wages are twice the nominal wages.",
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"text": "Over the whole period, nominal wages rose 1695-fold, and prices rose 152-fold. 1695 divided by 152 is 11.2, meaning that average wages in ",
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"text": " terms are 11.2 times higher today than back in 1750. If their great-great-grandfathers in 1750 had to work for a year to buy a representative consumption bundle, Brits today have to work for only a bit more than a month to buy a comparable bundle of goods and services.",
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"text": "The CPI is not the only index that can be used to adjust nominal monetary values. Its focus is on tracking the changes in the prices that ",
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"text": " face overall. But not all goods produced in an economy are purchased by consumers. Some goods are purchased by firms and used to produce final goods.",
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"text": " is another commonly-used index that tracks the price of all domestically-produced final goods and services in an economy, as measured by it\u2019s Gross Domestic Product (GDP). Statisticians calculating a country\u2019s GDP use data that is expressed in current prices \u2013 the nominal value of transactions between buyers and sellers of goods and services. The GDP deflator is then used to separate price changes within this nominal data, leaving a measure of the ",
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"text": "For example, in 2012, the UK statistical agency changed the composition of this basket of goods to better reflect the typical consumption basket of households. Tablet computers were added, demonstrating the effect of new technologies, while boiled sweets were removed, reflecting changing preferences. Gooding, Philip. \"Consumer Prices Index and Retail Prices Index: the 2011 basket of goods and services.\" Economic and Labour Market Review 5, no. 4 (2011): 96-107.",
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"type": "article",
"title": "How are incomes adjusted for inflation?",
"authors": [
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"excerpt": "Adjusting incomes for inflation is crucial if we want to learn how standards of living are changing. How is this adjustment done?",
"subtitle": "Adjusting incomes for inflation is crucial if we want to learn how standards of living are changing. How is this adjustment done?",
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1 | 2023-07-10 09:24:31 | 2023-07-11 07:04:22 | 2023-12-28 16:31:08 | listed | AGEZuMHE3XMsFF4dSd_kPfCJHTARVKbYuYwGCfqGSQG5xn1eJ7OAfOxmS1PSU0dW2RqMs34MyUc5QknImZyTVA | When looking at data on people’s incomes, it’s usually not the quantity of currency that we’re interested in. It’s what this quantity means for their standard of living – the quantity and quality of the _goods and services_ they can afford. To study this, we need to compare people’s incomes with the prices of the goods and services they can buy. These change over time – the prices on supermarket shelves that you remember from the past are typically not the same as you’ll see today. Adjusting for this is crucial if we want to use income data to understand how living standards are changing around the world. For this reason, almost all of the income data you’ll find on Our World in Data is adjusted for inflation. It’s important to note that here we’re referring to both positive and negative inflation. When incomes are adjusted for inflation, they are also at the same time adjusted for the opposite – _de_flation. But how is this adjustment done? # A simple example: adjusting incomes for the price of _one_ good A simple approach would be to adjust incomes for the change in the price of a_ single_ product that is commonly purchased – for example, a loaf of bread. If the price of bread doubles over a period, but your employer still pays you the same income, then you can only buy half as much bread. Your income, adjusted for the inflation of bread prices, has halved. The chart below shows historical data on the relationship between incomes and the price of another commonly purchased product: books. It looks at this relationship the other way around: it shows how long the average worker had to work to afford one book. We see that the price of a book, relative to incomes, rapidly declined with the invention of the printing press in the 15th century. This means the reverse is also true: incomes, relative to the price of books, rose dramatically. What was once totally out of reach for all but the richest elite – to own a book – became increasingly affordable to the majority. Only by comparing data on incomes to the prices of goods over time can we learn how people’s options and opportunities change. <Image filename="Ratio-of-book-price-to-daily-wages.png"/> # The Consumer Price Index: a measure of the _overall _change in prices_ _ Comparing incomes to the price of only one product has an obvious problem: changes in this price may not be representative of all the other products that consumers buy. Changes in the price of a loaf of bread, or a book, may differ from changes in the prices of medicines, heating, or computers. The price of some of these goods may increase while others decrease. When adjusting incomes for inflation, statisticians rely on a “_basket” of goods and services_ that are representative of the consumption of the average household. Since people buy different things in different countries, these household consumption baskets vary from country to country. The basket is also updated over time, as new technologies emerge making new goods or services available, and as consumption preferences change.1 Statisticians monitor the prices of all the products in this basket and calculate a weighted average: when calculating the overall price level, they give more importance to the products that people spend a large share of their income on. This average price level is then expressed relative to the price level in a chosen base year. This is known as the Consumer Price Index (CPI). In the base year, the CPI is equal to 100, and in other years it shows us the price level relative to that year. A CPI of 120 means that prices are 20% higher than in the base year. The following chart shows CPI data gathered from national statistical offices by the International Monetary Fund. The base year in this case is 2010, so a CPI of 120 means that prices rose by 20% since 2010. <Chart url="https://ourworldindata.org/grapher/consumer-price-index?country=IND~USA~JPN~ZAF~CHN~MEX"/> ## _Nominal_ incomes ‘deflated’ by a price index give us _real_ incomes The CPI allows us to compare incomes not to the price of one particular good, but to the broader cost of living. By adjusting incomes with the CPI, we learn not about how many books or loaves of bread people can buy, but about their options and opportunities for consumption more generally. Income data generally arrives to us in what’s called ‘nominal’ terms: without any adjustment for inflation. If you compare the figure on your paycheck to the figure ten years ago to understand how your income has changed, you are not considering how the price of goods also changed over that time. For this reason, nominal incomes are often referred to as incomes measured in ‘current prices’. _‘Real_ incomes’ is how researchers and statisticians refer to income data after it has been adjusted for inflation – or ‘deflated’, as it is sometimes called. The changes in _real_ incomes tell us the change in what people can _really_ afford. This is often referred to as income measured in ‘constant prices’: it tells us the amount of goods and services a person’s income could have bought if prices had stayed the same as observed in one particular year (the base year of the CPI). Such an adjustment is crucial for making meaningful comparisons over time. Only _real_ incomes – measured in terms of constant prices – give us an idea about how the prosperity of a population changes. ### An example: Adjusting wages for inflation in the UK To provide an example of an inflation adjustment, the chart below shows the evolution of average weekly wages in the United Kingdom. It shows three series: * _nominal_ wages – as measured before any inflation adjustment; * the _consumer price index_, used to track the average price level; * _real_ wages – after accounting for the change in the price level. Between 1750 and 2015, nominal wages in the UK increased from £0.29 to £492 per week. This is a 1695-fold increase. But with these higher nominal wages, workers cannot buy 1695 times the value of goods and services, because prices rose considerably over this time too. In this chart, 2015 is the base year used for the consumer price index: in 2015, it has a value of 100. In 1750 it has a value of 0.66. The ratio between these two observations – 100 divided by 0.66 – is 152, and this tells us that the average prices that consumers face increased 152-fold over these 265 years. To calculate the real wage increase, we need to look at the nominal wage increase compared to the increase in prices. The third line shows real average wages: nominal wages divided by the consumer price index, expressed as a fraction. In 2015, real and nominal wages are the same. In the late 1980s, when prices were around half their 2015 level, real wages are twice the nominal wages. Over the whole period, nominal wages rose 1695-fold, and prices rose 152-fold. 1695 divided by 152 is 11.2, meaning that average wages in _real_ terms are 11.2 times higher today than back in 1750. If their great-great-grandfathers in 1750 had to work for a year to buy a representative consumption bundle, Brits today have to work for only a bit more than a month to buy a comparable bundle of goods and services. <Chart url="https://ourworldindata.org/grapher/nominal-wages-consumer-prices-and-real-wages-in-the-uk-since-1750"/> # Other price indexes The CPI is not the only index that can be used to adjust nominal monetary values. Its focus is on tracking the changes in the prices that _consumers_ face overall. But not all goods produced in an economy are purchased by consumers. Some goods are purchased by firms and used to produce final goods. The _GDP deflator_ is another commonly-used index that tracks the price of all domestically-produced final goods and services in an economy, as measured by it’s Gross Domestic Product (GDP). Statisticians calculating a country’s GDP use data that is expressed in current prices – the nominal value of transactions between buyers and sellers of goods and services. The GDP deflator is then used to separate price changes within this nominal data, leaving a measure of the _volume_ of goods and services produced in an economy over time. There are two main differences between the CPI and the GDP deflator: * The GDP deflator tracks the prices of goods and services _produced_ in a country. The CPI, on the other hand, measures the prices of goods and services _consumed_ in a country – including those produced elsewhere and imported. * Secondly, the GDP deflator covers capital goods – goods not bought by consumers. You can read more about these two price indexes in a detailed guide produced by the OECD: _[Understanding National Accounts](https://www.oecd.org/sdd/UNA-2014.pdf)_. For example, in 2012, the UK statistical agency changed the composition of this basket of goods to better reflect the typical consumption basket of households. Tablet computers were added, demonstrating the effect of new technologies, while boiled sweets were removed, reflecting changing preferences. Gooding, Philip. "Consumer Prices Index and Retail Prices Index: the 2011 basket of goods and services." Economic and Labour Market Review 5, no. 4 (2011): 96-107. | How are incomes adjusted for inflation? |