Converting Nominal Dollars into Real Dollars

A frequently encountered problem in examining political or economic questions occurs when we look at money across time. For instance, if we look at the price of gasoline today, and compare it to the price of gasoline in 1966, or 1973, or 1979, we find that the price has risen over 15 fold, from 28cents/gallon to $3.60/gallon in 2012. That is a 1300% increase in 45 years. This appears to be an enormous rise in the price.

But to look at the price paid for a commodity at the time it was purchased fails to account for an important economic condition - inflation! In other words, because there has been inflation, a generalized increase in the selling price for goods and services as well as increases in the wages paid for the same level of work across all sectors of the economy, the purchasing price of the dollar has decreased. What a dollar buys today is less than what it bought 40, 30, 10, or even 2 years ago. When we account for inflation we are saying "What did something cost when we account for the changes in the purchasing power of the dollar?"

To do this we use a Price Deflator, or a Consumer Price Index. An example will help us understand how and why we 'deflate' current dollars.

Get the Consumer Price Index (see tutorial)

To convert the price of gas example to real dollars, use the following formula:

So if the CPI for 1966 was 32.92, and the current CPI is 202.5, then we can convert 1966 gas prices to 2006 gas prices with the following equation.

While gas is more expensive today, it is not really all that much more so!

In fact, when gasoline toped $1.00 a gallon in December 1974 during the Arab Oil Embargo, the real price of gas was even higher!

Try examining defense spending from 1954 to 2004 with this data set:

US Budget 1940-2012