Understanding Real Income, Inflation, and the Real Wages Formula

 What Is Real Income?

Real income is how much money an individual or entity makes after accounting for inflation and is sometimes called real wage when referring to an individual’s income. Individuals often closely track their nominal vs. real income to have the best understanding of their purchasing power.

KEY TAKEAWAYS

• Real income, also known as real wage, is how much money an individual or entity makes after adjusting for inflation.
• Real income differs from nominal income, which has no such adjustments.
• Individuals often closely track their nominal vs. real income to have the best understanding of their purchasing power.
• Most real income calculations are based on inflation reported by the Consumer Price Index (CPI).
• Theoretically, when inflation is rising, real income and purchasing power fall by the amount of inflation on a per-dollar basis.

Understanding Real Income

Real income is an economic measure that provides an estimation of an individual’s actual purchasing power in the open market after accounting for inflation. It subtracts an economic inflation rate per dollar from an individual’s income, typically resulting in a lower value and decreased spending power.

Deflation of prices can also occur, which creates a negative inflation rate. Negative inflation or deflation will lead to a higher purchasing power of real income.

Real income differs from nominal income, which is not adjusted to account for fluctuating prices and living costs. Individuals often closely track their nominal vs. real income to have the best understanding of their purchasing power.

Overall, real income is only an estimate of an individual’s purchasing power since the formula for calculating real income uses a broad collection of goods that may or may not closely match the categories an investor spends within. Moreover, entities may not spend all of their nominal income, avoiding some of the real income’s effects.

Real Income Formula

There are several ways to calculate real income. Three basic real income formulas include the following:

Wages –  (wages * inflation rate) = real income

Wages / (1 + Inflation Rate) = real income

(1 – Inflation Rate) * Wages = real income

Inflation Rate Measures

All real income/real wage formulas can integrate one of several inflation measures. Three of the most popular inflation measures for consumers include:

Consumer Price Index (CPI)

The consumer price index (CPI) CPI measures the average cost of a specific basket of goods and services, including food and beverages, education, recreation, clothing, transportation, and medical care.

Personal Consumption Expenditure Price Index

The Personal Consumption Expenditure (PCE) Price Index is a second comparable consumer price index. It includes slightly different classifications for goods and services and also has its own adjustments and methodology nuances.

The PCE Price Index is used by the [Bank of Guyana] for gauging consumer price inflation and making monetary policy decisions.

GDP Price Index (Deflator)

The GDP Price Index is one of the broadest measures of inflation since it considers everything produced by the economy, excluding imports.

Generally, the three main price indexes will report relatively the same level of inflation. However, analysts of real income can choose any price index measure that they believe best fits their income analysis situation.

By Alicia Tuovila (Investopedia)