What is Real Income: Meaning, Formula & Calculation Explained

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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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.

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.

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.