Wednesday, December 14, 2005

Let's Get Real

I have a few very odd pet peeves (the word "pet peeves" being the largest), and one of them is articles that either confuse or fail to distinguish between real and nominal terms. Skip to the end of this post, or skip it entirely if you already understand real vs. nominal.

What does real and nominal mean? Well, it is simple but a bit complicated to explain, so I'll use a few examples.
  1. Real dollars: Lets say a bottle of coke costed $.10 in 1920 and a the same size bottle of coke cost $1.00 in 2005. Thus, the (nominal) price of a coke went up 10 fold in 85 years. Adjusted for inflation that can of coke cost $.97 2005 dollars in 1920 and $1.00 2005 dollars in 2005. That is to say, in this example over 85 years the price of coke has risen only 3 cents. Thus we can get to the definition of real dollars as "dollars adjusted for the change in purchasing power due to inflation," or perhaps more easily understood "the prices that would be if there were no inflation." ( inflation numbers from this table)
  2. Real interest: In one year your bank deposits are earning 10% interest. The government conducts an agressive anti-inflation campaign and a few years later you're only getting 5%. In which period were you better off? The answer depends on if the rates I have given are real (adjusted for inflation) or nominal (in units of that year). Lets say that the rates are nominal and that inflation in the first year was 7% and in the second it was 2%. What then is your real rate of interest? It turns out, it was 3% both times because Real interest rate = nominal interest rate - inflation rate.
Any time you are talking about "inflation adjusted" prices or interest rates you are by definition talking about "real" prices. Non-inflation adjusted prices are nominal prices (which means nothing more than "prices in name").

If you are going to take only one thing away from a basic economics course, an understanding of real and nominal rates comes second only to supply and demand. Think about this, understand it, love it. It is one of those concepts that will completely change the way you view the world once you have mastered it (and it will allow you to read through the bullshit of half the news articles you read).

What has me thinking about this is a set of "the sky is falling" articles I have been reading recently about how our generation is "the most indebted" generation. In all of these articles I am seeing nominal numbers used to 'prove' that we are worse off than our parents.

Now, don't get me wrong, student loan debt isn't pretty. But, I can't help but think that the situation might not be as bad as everyone (the, sky, is, falling!) is saying it is. So, consider this a primer for a post I'll be putting up this weekend where I'm going to run the numbers and see if we're worse off than our parents. I'll admit that my initial hunch is that all of this "the most indebted generation" talk is a bunch of bullshit, but we'll see what the numbers tell me once I've run them. But then again, I do have a bit of skin in the game in us being called the "I want now" generation.

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