Real Income

Published Oct 25, 2023

Definition of Real Income

Real income refers to an individual’s purchasing power, or the goods and services that can be purchased with a given amount of money. Unlike nominal income, which is the actual amount of money received, real income takes into account changes in purchasing power due to inflation or changes in the cost of living.

Example

To understand real income, let’s consider an example. Suppose an individual earns a monthly salary of $3,000. In the current year, the inflation rate is 3%. Without considering inflation, the individual’s nominal income remains the same at $3,000. However, due to the increase in prices caused by inflation, the purchasing power of that income decreases. In other words, the individual can buy fewer goods and services with the same amount of money.

To calculate the individual’s real income, we adjust the nominal income for inflation. In this case, with a 3% inflation rate, the real income would be $2,911. The individual’s purchasing power has decreased by $89 due to inflation.

Why Real Income Matters

Real income is an important concept because it reflects the actual purchasing power of an individual’s income. When looking at changes in income over time, it is essential to consider changes in the cost of living. By taking into account inflation or changes in the price level, real income provides a more accurate measure of an individual’s economic well-being. It helps individuals understand how much they can afford to buy with their income and allows for meaningful comparisons of income levels across different time periods or locations. Additionally, real income is a crucial factor in economic analysis and policy-making, as it affects consumption patterns, standard of living, and overall economic growth.