Real Income: Definition, Formula, and Calculation Guide

Inflation impacts an individual's purchasing power. For instance, if a commodity's market price increases while a consumer's salary remains the same, it creates a gap that affects his or her purchasing power. Real income is an economic measure that considers this inflation and highlights a person's financial stability and purchasing power.

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What Is Real Income?

The meaning of real income is the inflation-adjusted earnings of an individual or a country. It is also known as real wage when denoting an individual's income. It accounts for the number of goods and services bought with the income earned and thus, indicates the well-being of a consumer.

What Is the Formula to Calculate Real Income?

There are primarily three basic formulas through which individuals can compute real income:

Real Income = Wages - (Wages x Inflation Rate)
Real Income = Wages / (1 + Inflation Rate)
Real Income = (1 – Inflation Rate) x Wages

Individuals can integrate one from any of the three popular inflation measures into real income formulas:

1. Consumer Price Index

CPI, or consumer price index, estimates the average price of goods and services, including education, foods and beverages, clothing, transportation, recreation and medical care.

2. Personal Consumption Expenditure Price Index

This index is comparable to CPI; however, it contains a slightly distinct categorisation for goods and services. Moreover, it features different adjustments and methodology and is mainly used to compute price inflation and make decisions on monetary policies.

3. GDP Price Index

This is the most comprehensive index to measure inflation since it factors in every production in an economy, excluding imports.

How Is Real Income Calculated?

The calculation of real income can be better understood with a simple example. So, let's take a look:

Suppose Mr Alok earns an annual nominal income of ₹ 60,000. He uses the consumer price index to calculate his annual real wage rate. Now, say, the consumer price index reported an inflation percentage of 2.4%. So, by using the formula – Real Income = [Wages / (1 + Inflation Rate)], the result will be –

Particulars	Amount
Annual nominal income	₹ 60,000
Inflation rate	2.4%
Formula used	[Wages / (1 + Inflation Rate)]
Annual real wage	₹ 58,594

Note that this is an annual inflation-adjusted real wage. Individuals can also divide their nominal income by months, weeks and hours and adjust it with the subsequent change in the inflation rate.

What Is the Effect of Real Income on Purchasing Power?

When the inflation rate increases, the real income of individuals decreases and vice versa.

Taking a cue from the above example, Mr Alok spends ₹ 1,000 per month for purchasing food out of ₹ 60,000, which amounts to 12,000 per year. At the same time, inflation is increasing by 1% annually; however, Mr Alok's nominal salary remains the same.

Thus, with a ₹ 60,000 nominal salary per year, Mr Alok loses purchasing power of nearly ₹ 600 for a year due to inflation (or one per cent with each rupee spent). If he is not following a stringent budget, he will likely spend around ₹ 1,010 per month or ₹ 12,120 per year to buy the same quantity of food purchased at a comparatively lower price in the past year. Thus, his expenses increase annually, but his salary remains constant, and this is how the inflationary rise in prices impacts his real income.

Thus, carefully go through the details of the real income as mentioned above. Knowing such information will assist individuals in assessing their purchasing power and managing their expenses and overall budget accordingly.

Frequently Asked Questions

All

What is the difference between nominal and real income?

In the case of real income, it is adjusted with an inflation rate, and it varies with each year. On the other hand, nominal income is the earning that is not inflation-adjusted and remains fixed for years.

Does the real income of bond and debenture holders decrease with inflation?

Yes, bond and debenture holders receive fixed earnings on their investment and hence when there is an increase in the price level, their real income decreases.