Inflationary Gap

And finance Allah shmoop What are riel versus nominal wages

Well old Grandpa Larry has been retired for a while

so he's a bit out of touch When I was

your age burgers cost a quarter Now they're five dollars

five dollars Everything so expensive nowadays Oh Grandpa and guess

There he goes again being either sarcastic or totally not

getting that Inflation is a you know a thing Well

inflation is the reason prices and wages or nominal wages

to be precise there That's the reason they rise Inflation

Your nominal wage is the actual dollar amount on your

paycheck And on Grandpa you know when he a bad

one for you Maybe it's a three grand a month

for grandpa while it was three grand for the whole

year So grandpas not exactly wrong Everything was in fact

cheaper nominally cheaper back in the day But nominal incomes

were also lower Today the sticker price on everything is

much higher but so are our paychecks Where grandpa is

steered wrong is that well he's only thinking of prices

rising not income if prices rise But buying power also

rises Well then things aren't necessarily Mohr expensive or at

least not relatively more expensive What Grandpa doesn't get is

that he's looking at nominal wage rates when he should

be looking at the real wage rate Well the rial

wage rate is the money you make once you take

into account the effects of inflation on buying power While

your nominal paycheck is much larger than grandpas while you're

really wage rate might be pretty similar to what his

was in the nineteen fifties Riel wage rates allow us

to compare the amount of buying power different people have

or well had And that's what counts right Sure you

can buy a lot of things if you're a millionaire

today But as inflation raises prices for many decades down

the line being a quote millionaire unquote in nominal terms

it might be pretty average inflation which is what creates

the difference between nominal and real wages is the reason

you really really shouldn't save up cash in your sock

drawer under your match Chris was just sitting there doing

nothing You're much better off keeping your money somewhere where

it can at least gain a little interest income ideally

enough to keep up with inflation which is around two

or three percent a year on most years Think about

it this way If Grandpa Larry put a five dollar

bill in his sock drawer in the nineteen fifties that

five dollars was worth twenty burgers at the time right

A quarter a burger If he took out that same

five dollar bill from his sock drawer today he'd only

be able to buy one burger with it Just won

all that inflation over all those years Eroded the burger

buying value of that five dollar bill from twenty burgers

down to a single burger If you want to keep

your buying power up while the money you have lying

around needs to earn a two or three percent interest

a year if your nominal savings keeps up with inflation

while your riel savings will retain its riel buying power

If Grandpa Larry put that five dollars in the bank

accounts that yielded me let's call it two percent Well

then he'd be able to buy a lot more with

it than just one burger today Although he's not totally

wrong about burgers that is getting more expensive If you'd

put that five dollars in a bank account seventy years

ago and it grew a two percent a year well

at five dollars would now be twenty dollars which means

it grew three hundred percent of the price of burgers

though rose from a quarter to five dollars in the

same time which comes out Tio nineteen hundred percent well

While his five dollars was keeping up with inflation it

wasn't growing as fast as the cost of burgers So

the rial price of burgers actually did go up Even

on a relative basis The Consumer Price index helps us

see real price changes like these For instance the real

price of college and health care have risen by a

substantial amount way higher than the rate of inflation That

means it takes more buying power than it did before

to pay for those things which is a bigger cut

out of people's paychecks than ever before So maybe Grandpa

Larry is an entirely senile yet after all but he's

getting there