Real income is adjusted for inflation. It is contrasted with nominal income, which does not take the effects of inflation into account. Real income is based on the tangible goods or services, such as milk or bread, that money can buy. In macroeconomic calculations, it is often the preferred method of gauging changes in income over time or between different countries.
Inflation is a decline in the value of a given amount of money over time. Most economists agree that long-term inflation is the result of an increase in the money supply—for example, when a government prints more bills. This relationship between the total amount of money and prices is called the quantity theory of money. British economist John Maynard Keynes, on the other hand, argued that inflation was also affected by factors such as the level of private spending. In any case, the effects of inflation are an important part of economic and financial decisions.
Though inflation reduces the number of goods and services an amount of money can buy, a majority of economists agree that some level of inflation has an overall positive effect on the economy. It encourages individuals and businesses to spend money now rather than later, which spurs economic growth. Without inflation, money would be worth more in the future; people would be encouraged to hoard their money rather than spend it.
If the inflation rate was 5%, a person’s nominal income of $30,000 US Dollars (USD) would have to increase by 5% each year to keep a steady real income. Any nominal income less than $31,500 USD the following year would constitute a reduction in real income. Real income can be calculated by taking the nominal income and subtracting the annual inflation rate.
Real income is the preferred method of measuring income in a variety of different circumstances. It could be useful when evaluating the potential for future raises in a job. If an employer promised a 2% raise in salary each year, but the inflation rate remained at 3%, it would not be a very good deal. This would mean that one’s real income would actually drop by 1% each year, rather than rise at all. The employee could buy fewer real-world goods each year in this situation.
Researchers often use real income when calculating general trends in an economy. A real income figure is much more useful when comparing income levels from different times in history. The average wage in the United States in 1960, for example, was $4,007.12 (USD). It is difficult to imagine whether this is high or low if you don’t know how much this money could have bought in 1960.