Question

(Related to Solved Problem 20.5 on page 683 ) In 1924 , the famous novelist F. Scott Fitzgerald wrote an article for the Saturday Evening Post titled "How to Live on \(\$ 36,000\) a Year," in which he wondered how he and his wife had managed to spend all of that very high income without saving any of it. The CPI in 1924 was \(17,\) and the CPI in 2016 was 240 . What income would you have needed in 2016 to have had the same purchasing power that Fitzgerald's \(\$ 36,000\) had in \(1924 ?\) Be sure to show your calculation.

Short answer

In order to have the same purchasing power in 2016 that $36,000 had in 1924, you would have needed an income of approximately $507,058.82.

Step-by-step solution

Understand the Expression

First, it's important to understand that the change in the CPI from 1924 to 2016 implies a change in the purchasing power of money. In other words, a dollar in 1924 could buy more goods and services than a dollar in 2016 could, because inflation erodes the value of money over time. This can be represented as a ratio where the CPI in 1924 is the numerator and the CPI in 2016 is the denominator. This gives us the fraction 17/240.

Calculate the Equivalent 2016 Income

We will multiply Fitzgerald's 1924 income by the ratio of the 1924 CPI to the 2016 CPI. This will give us the equivalent 2016 income necessary to have the same purchasing power as $36,000 in 1924. So, we calculate \(36,000 \times \frac{240}{17}\) which equals $507,058.82, when rounded to the nearest cent.

Key concepts

CPI (Consumer Price Index)

The Consumer Price Index (CPI) is an essential economic tool used to measure changes in the price level of a market basket of consumer goods and services purchased by households. This index reflects how prices fluctuate over time, documenting inflation or deflation. In essence, it serves as a benchmark for the cost of living adjustments.

When comparing different years, the CPI helps determine how much you would need in today's money to match the purchasing power of money from another time. For example, if the CPI is higher in 2023 than in 1924, this indicates that prices overall have increased, and you would need more money today to buy the same goods and services you could back then.

Using the CPI to adjust for purchasing power is crucial for historical income evaluations and understanding economic conditions across different time periods. This index shows how the economic value of money has transformed over the decades, influenced by inflation, cost of living changes, and other economic variables.

Inflation

Inflation describes the rate at which the general level of prices for goods and services rises, eroding purchasing power. This means that over time, money buys fewer goods, leading to a decrease in the value of money. A high inflation rate indicates that prices are increasing rapidly, requiring more money to maintain the same standard of living.

Inflation is measured via the CPI, among other indices, to reflect the rate at which the cost of living increases. For instance, if the CPI increases significantly over several years, it indicates that inflation is occurring since the cost of goods and services has risen.

This is the main reason why someone in 1924 could live on $36,000, whereas the amount required in 2016 to have the same lifestyle drastically increased to approximately $507,058.82 due to the effect of inflation.

Historical Income Adjustments

Adjusting historical income using price and spending measures like the CPI allows individuals and policymakers to make meaningful comparisons across different time periods. This process involves recalibrating past monetary values to reflect equivalent current purchasing power.

For example, historical income adjustments consider what the same amount of money from the past would be worth today. In the context of the exercise, by multiplying Fitzgerald's 1924 income of $36,000 by the ratio of the CPIs from 1924 and 2016, we calculate what that income would need to be in 2016 dollars: $507,058.82.

This adjustment is vital in understanding economic history, policy making, and even budgeting for historians and economists who try to understand how income and living standards have changed over time when factoring in inflation.