Why Real Wages Should Be Adjusted for Inflation

Most introductory economics textbooks leave readers with the impression that raising savings to keep pace with inflation preserves their purchasing power. However, this is not entirely accurate. In reality, there are two distinct types of price adjustments: the core price adjustment (which offsets the falling value of money) and the real economic price adjustment (which balances supply with demand). When both of these adjustments are added together, we arrive at the nominal price index. This index is not the same as the core adjustment rate.

The Core Rate vs. Nominal Price Index

The core rate is the rate at which the value of money is adjusted for inflation, whereas the nominal price index reflects the changes in the prices of goods and services used in a specific basket. While these rates are closely related, they are not identical. Over a 100-year period, the difference between a 3% annual real rate of growth of earnings and the price index can be staggering. The price index might lose 99% of its value for savers, while earnings could grow significantly, thus emphasizing the importance of understanding the core adjustment rate.

Unadjusted Core Rates in Practice

Several economic elements do not adjust their core rates properly, including:

Fixed interest bond maturity values: You get money back, not value back Mortgage and loan repayment costs: These do not adjust as expected and can fluctuate Currency prices: Do not self-adjust, especially for trading purposes Interest rates: These are managed by the market, not free market prices

When these core rates are improperly adjusted, the National Average Earnings (NAE) rate may not accurately represent the true value of wages over time. This is significant because if savings and wages keep pace with the NAE, rather than the nominal price index, the value of those savings will be preserved. For instance, a private pension could rise as fast as if the individual were still working, aligning with the NAE growth rate.

New Economic Models and Key Insights

The recent work of economists like Google's Ingram Economics or the Ingram School of Economics offers new perspectives on this issue. They advocate for a scenario where all prices, costs, and assets adjust their core rates properly. In such a scenario, the NAE would align more closely with the rate required to preserve the value of savings. When savings grow at the same pace as NAE, not prices, the value of those savings is maintained.

Key insights include:

Preserving the value of money is more crucial than preserving its purchasing power, especially over long periods. Adjusting all economic elements to align with core prices can help prevent money from losing value, as advocated by John Maynard Keynes in 'A Tract on Monetary Reform'. Managing inflation by adjusting economic output and creating additional money where needed can protect financial plans and ensure savings and pensions are secure. A direct and effective way to stimulate the economy is to provide additional spending for everyone, not just through trickle-down effects.

Conclusion

The proper adjustment of real wages for inflation goes beyond simply keeping pace with the nominal price index. It requires a comprehensive approach that addresses both core and real economic price adjustments. By doing so, economic stability can be maintained, and financial security can be ensured. The insights from new economic models offer a promising path towards achieving these goals.