What does "Constant Dollars" Mean?

Constant dollars is the term used for measuring the value of the Unites States dollar in terms of value at a previous point in time. This metric is useful in measuring the dollar's value factoring in inflation or deflation that may occur over time. Measuring constant dollars requires a calculation that utilizes the consumer price index, or CPI, values of both the current year and the year in the past against which the current value is being measured. There are many useful applications for the measurement, which puts prices, wages, and earnings into a historical perspective.

As time passes, the value of a single unit of any currency changes, and in the United States the value of the dollar has risen dramatically throughout the nation's history. Comparing what something costs now with what it cost at some point in the past is somewhat worthless as an exercise without some way of relating those costs with the prevailing value of the dollar at both points in time. Using the concept of constant dollars solves this conundrum, as it takes into account the effect of inflation or deflation on dollar values.

Evaluating the value of the dollar through time is done in concert with the consumer price index (CPI), which is an index that reflects the cost of living in the U.S. at the time when it is calculated. To calculate the constant dollars of an amount of current dollars compared to a previous year, the CPI of the previous year is divided by the current CPI. That number is then multiplied by the current dollar total.

For a simple example, imagine that the current consumer price index is 125 and the CPI of two years ago is 75, and that the amount of current dollars in question is $1,000 US Dollars (USD). The CPI of 75 is divided by 125, yielding a total of 0.60. This total of 0.60 is then multiplied by the $1,000 USD, leaving a product of $600 USD. That means that $600 USD two years ago would be worth as much as $1,000 USD is now.

If someone wanted to figure out how much a previous amount of money would be worth today, the equation would be the same except that the CPI totals would be inverted in the division problem. This means that the current year's CPI is divided by the previous year's CPI, a total then multiplied by the amount of dollars in question from the previous year. Constant dollars allow anyone to measure the worth of some amount of money. It can be useful for businesses measuring their profits, for the U.S. government studying debt amounts, or even for individuals trying to determine if their wages are properly attuned to inflation amounts.