11.2 Correcting Economic Variables for the Effects of Inflation

11.2 a. Dollar Figures from Different Times

Amount in today’s dollars = Amount in year T’s dollars * (Price level today)/(Price level in year T ^[4]

Salary in 2005 = Salary in 1931 *(Price level in 2005)/(Price level in 2931) = $80,000 *195/152 = $1,026,316 ^[4]

^{Calculating Dollar Figures [12]}

11.2 b. Indexation

Indexation is linking adjustments made to the value of a good, service or other metric, to a predetermined index. ^[8]

Example: Businesses may use indexation to match an employee’s salary to the inflation rate, meaning that an increase in the inflation rate over a period of time, will lead to an increase in salary. ^[8]

^{Indexation to adjust to inflation [9]}

11.2 c. Real and Nominal Interest Rates

The nominal interest rate is, in essence, the actual monetary price that borrowers pay to lenders to use their money. ^[10]

Example: If the nominal rate on a loan is 5%, then borrowers can expect to pay $5 of interest for every $100 loaned to them. ^[10]

The real interest rate is so named because it states the “real” rate that the lender or investor receives after inflation is factored in; that is, the interest rate that exceeds the inflation rate. ^[10]

Example: If a bond that compounds annually has a 6% nominal yield and the inflation rate is 4%, then the real rate of interest is only 2%. ^[10]

^{Real and Nominal Interest Rates [11]}