Reviewed by Aug 27, 2020| Updated on
What is Meant by Real Income?
Real income is the earnings of individuals or the nation after adjusting to the extent of inflation. It is computed by dividing the nominal income by the price level. Both the real variables, such as real income and real GDP, must be measured in physical units. In contrast, nominal variables, such as the nominal income and nominal GDP, will be measured in monetary terms.
Consequently, real income is better and a useful indicator of the well-being since it estimates the count of goods and services purchased with the earnings.
As per the classical dichotomy theory, both real variables and nominal variables are distinct in the long run, so they are not affected by each other.
Suppose that the nominal income at the beginning is Rs 100 and the inflation is 10% every year ( i.e. general rise in prices). If the nominal income continues to be Rs 100 next year, one can buy less to the extent of roughly 9%. Therefore, if nominal income has not been adjusted for inflation every year (i.e. increased by 10%), the real income has dropped by about 9%.
The Formula for Real Income
There are alternative ways to calculate real income. The basic real wage or real income has two formulae, such as the following:
Real Income = Wages - (Wages x Inflation Rate)
Real Income = Wages / (1 + Inflation Rate)
Real Income = (1 – Inflation Rate) x Wages
One of the several inflation indexes can be incorporated into all real income/real wage formulas. Three of the most popular consumer inflation measures are:
1.The Consumer Price Index (CPI) 2. The PCE Price Index 3. The GDP Price Index
The three major price indices would generally report about the same level of inflation. Real income analysts, however, can choose any price index indicator they think fits their income analysis situation best. Note that price deflation can also occur and it can cause a negative rate of inflation.
Effect on Purchasing Power
In general, the impact of inflation on wages would influence an individual consumer's purchasing power. If prices on the market are increasing, but customers are paying the same salary, then a gap is generated, which leads to an impact on the buying power.