Money decreases in value over time. As the economy and the money supply expands, prices rise, which reduces money's purchasing power. Central bank action, unemployment and the expectation of higher prices all contribute to inflation. As a result, an item's price, measured in today's dollars, may not represent its value. The real value of money describes a sum's value in terms of an earlier reference year's dollars. Economists calculate this change in the value of money using the Consumer Price Index, or CPI, which grants extra weight to the changing prices of the economy's more significant items.
The Consumer Price Index, or CPI, is an excellent gauge of how an economy is fairing. By tracking the price of an individual item over a series of months or years, you can integrate these figures into the CPI formula to understand how inflation has affected pricing.
How the CPI Is Used
Before you start calculating, you may wonder why you might need to perform this calculation. The CPI is used for adjusting prices for inflation. Say, for instance, a government entity wants to determine the income requirements to qualify for public housing. The CPI could determine whether those maximum qualifications should be adjusted for inflation. It can also be used on a general basis to determine how government policies are affecting the overall economy.
Determine Price and Quantity
Before you get started, you'll need to put some time into pulling figures on prices you want to follow. Note the prices and quantities in multiple periods for all goods whose data you have. For this example, suppose that you are calculating the real value of 2018 money in terms of 2008 prices. Assume, for example, that people in 2018 bought 100 bananas at $15 each and 80 knives at $20 each. Then assume that people in 2008 bought 90 bananas at $12 each and 65 knives at $18 each.
Multiply together each item's price and quantity for the year. Continuing with the example from the previous step using 2008 prices and quantities: $15 × 100 = $1,500; $20 × 80 = $1,600. Add these results: $1,500 + $1,600 = $3,100.
Calculate Real Value
Repeat the previous two steps for the year from which prices you're using as a reference for the money's real value. With this example, using 2008 prices and quantities: (90 × $12) + (65 × $18) = $2,250. Divide this dollar amount by the amount you arrived at from 2008 prices and quantities: $2,250 ÷ $3,100 = 0.7258.
Multiply the amount whose real value you want to calculate by this ratio. For example, if you want to find the real value in terms of 2008 dollars of $10,000 in 2018 dollars: $10,000 × 0.7258 = $7,258.