Monday, May 5, 2008

Understanding Real Income

One of the interesting results of "thinking economically" is learning to put things in "real terms". Whether I'm analyzing an effect, or helping my youngest understand his choices with his allowance, translating monetary income into something substantial can often lead to changes in decision-making.

When teaching personal finance or economics, I spend some time developing the idea of "real income". This is your income adjusted for inflation. Another way of looking at it is your income measured by what it will actually purchase. When developing this idea, I try to explain that focusing on nominal income (the wage you receive in monetary terms) may be deceptive. An examination of real income (what can be purchased with the wage) may be a better measure of personal and national economic progress. To do this, I try to develop the idea of personal basket of goods. This is not unlike the "market basket" that is used to define and measure the Consumer Price Index (CPI) which is the headline measure of inflation. One can spend a lot of time explaining why the CPI is a good index, but a less good measure of inflation. But the very thing that makes it a good index is helpful in developing the idea of real income.

There was an article in the Saturday (May 3) edition of The New York Times that explained the components of the CPI. The title of the article is deceptive, because it implies that if the item is not in the chart, it doesn't count for inflation. I don't want to go there. Rather I encourage you to examine the chart, using the interactive components to get a good sense of the market basket. Because once that's clear, your students can more easily understand how price changes (up or down) affect their real income.

For purposes of explanation, you can have the students look at all the components and then ask them, what has to happen if the price of one component rises (or falls). Given the assumption that the external boundary (nominal wage) is more or less fixed, the choice is consumer less (or more, respectively) of the product with the changes price. This will keep the proportion the same. But if the amount of the product is not changed to reflect price, the difference will have to show up as changes in other consumption. This is helpful in a number of ways, even in explaining what happens to personal budgets when food and gasoline prices rise.

Play around with this and consider bookmarking it. I think it's a keeper. What are your thoughts?

(HT to Mark Perry at Carpe Diem.)

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