The equation given, which expresses the relationship between the real price of a good, its nominal price, and the Consumer Price Index (CPI), demonstrates how to convert nominal prices into real prices. The formula is:
Real Price = (Nominal Price / CPI) x 100
This process helps us understand the price of a good in terms of its purchasing power in a particular base year. When we say ‘deflating,’ we’re essentially adjusting the nominal price to remove the effects of inflation, allowing us to see the true value of that good without the distortion caused by rising prices over time.
For example, if a good was priced at $120 today, and the CPI is 120, the real price would be:
Real Price = ($120 / 120) x 100 = $100
This means that, in terms of the purchasing power from the base year (when the CPI was set to 100), the good’s price reflects $100, not $120. Thus, deflating the nominal price gives a more accurate representation of the good’s value over time, adjusting for the unavoidable increase in prices due to inflation.