Inflation-adjusted Earnings
As we saw in the previous section, the existence of inflation tends to distort economic data that has a price component - sales, profit, income, GDP, interest rates, and average weekly earnings. To correct for any inflationary distortion, we need a simple transformation of the original data to differentiate real from nominal earnings. Everyone who lived through the 1970s knows all too well that wage increases can be eroded by rapidly rising prices. As we saw in the previous section, the existence of inflation tends to distort economic data that has a price component, including sales, profit, income, GDP, interest rates, and average weekly earnings.
To correct for any inflationary distortion in a variable economists construct a new variable known as the real, constant dollar, or inflation-adjusted variable. The key concept in the adjustment is the price index, some measure of the price level. The procedure is quite simple and requires only a simple transformation of the original data. In the following example you will see how nominal (actual) wage data are corrected to arrive at the inflation adjusted figure. The formula, which looks very much like the GDP formula is:
R = N/PI *100
where
How much does the adjustment matter? As you can see from the diagram below, it matters a lot. The general decline in inflation adjusted earnings is one of the more notable features of the period following the 1973 OPEC induced recession - as well as hotly debated.
The adjustment for inflation does not, however, end the controversy. Some suggest that the more appropriate measure of the price level should be the Consumption Price Deflator (PCE). As you can see from the diagram below, the use of the PCE would lower the growth in the price level which would raise inflation-adjusted wages.
There is also the appropriate measure of of earnings. If we used the Employment Cost Index for total compensation we see that it rises faster than the ECI for wages and average weekly earnings.
If we now compare the high and low estimates of real earnings the significance of the choices is obvious. In the high estimate, ECI total compensation deflated by the Consumption deflator rises 12 percent between 1980 and 1997. When using the average weekly earnings data deflated by the CPI, we have real wages falling 7 percent during the same period.
Now that we have muddied the water, let's move on to a discussion of unemployment - the measure success that the labor market has in finding jobs for all those looking for work.