How to Calculate the Real Value of Money Using the CPI Formula
Original post by Ryan Menezes of Demand Media
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 (CPI), which grants extra weight to the changing prices of the economy's more significant items.
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 2010 money in terms of 2000 prices. Assume, for example, that people in 2010 bought 100 bananas at $15 each and 80 knives at $20 each. Then assume that people in 2000 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 2010 prices and quantities: $15 --- 100 = $1,500; $20 --- 80 = $1,600.
Add these results: $1,500 + $1,600 = $3,100.
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 2000 prices and quantities: (90 --- $12) + (65 --- $18) = $2,250.
Divide the dollar amount from Step 4 by the amount from Step 3: $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 2000 dollars of $10,000 in 2010 dollars: $10,000 --- 0.7258 = $7,258.
- United States Naval Academy: Calculating a Laspeyres Price Index
- "Consumer Price Index Manual: Theory and Practice"; Ralph Turvey, International Labour Office; 2004
About the Author
Ryan Menezes is a professional writer and blogger. He has a Bachelor of Science in journalism from Boston University and has written for the American Civil Liberties Union, the marketing firm InSegment and the project management service Assembla. He is also a member of Mensa and the American Parliamentary Debate Association.
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