What Is Real Income?

Real income is how much money an individual or entity makes after accounting for inflation. It 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.

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. As such, the measure subtracts an economic inflation rate per dollar from an individual’s real wage, typically resulting in a lower value and decreased spending power. There are a few inflation measures an individual can use when seeking to calculate real income.

Overall, real income is only an estimate of an individual’s real wages 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 real income’s effects. Savvy individuals and most businesses keep a close watch on the economic inflation rate, using it as a basis for investment in risk-free vehicles.

Key Takeaways

  • Real income is how much money an individual or entity makes after accounting for inflation.
  • Most real income calculations are based on inflation reported by the Consumer Price Index.
  • Theoretically, when inflation is rising, real income and purchasing power fall by the amount of the inflation increase on a per dollar basis.

Real Income Formula

There are a few ways to calculate real income. Two basic real income or real wage formulas include the following:

Wages -  (Wages x Inflation Rate) = Real Income

Wages / (1 + Inflation Rate) = Real Income

(1 – Inflation Rate) x Wages = Real Income

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

  • The Consumer Price Index (CPI). The CPI measures the average cost of a specific basket of goods including food and beverages, education, recreation, clothing, transportation, and medical care. In the United States, the Bureau of Labor Statistics publishes CPI numbers monthly and annually.
  • The PCE Price Index. The PCE Price Index is a second comparable consumer price index. It includes slightly different classifications for goods and services. It also has its own adjustments and methodology nuances. The PCE Price Index is used by the Federal Reserve for gauging consumer price inflation and making monetary policy decisions.
  • The GDP Price Index. The GDP Price Index is one of the broadest measures of inflation since it considers everything produced by the U.S. economy.

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. Keep in mind, that 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.

Special Considerations for Investing

Many individuals and businesses invest a significant portion of their income in risk-free investment products and vehicles that match or exceed the economic inflation rate in order to mitigate the effects of inflation on their income. There are several risk-free investments that offer a return of approximately 2% or more. These products include high yield savings accounts, money market accounts, certificates of deposit, Treasuries, and Treasury Inflation-Protected Securities (TIPS). Beyond that investors may be willing to take on slightly more risk in order to keep their income yielding at or above inflation. For more sophisticated investors, municipal and corporate bonds are often used for obtaining 2%+ returns, beating inflation and helping income to grow steadily over time.

Real Wage Rates

When following real wages, there may be several real wage statistics to consider. A real wage rate can be a basic calculation of an individual’s hourly, weekly, or annual rate after adjusting for inflation. As such, having an expectation for a real wage rate can be just as important as a career expectation for a nominal wage rate.

The Bureau of Labor Statistics (BLS) releases a monthly real earnings report which can be helpful in following real wage rates. The “December 2018 Real Earnings” report shows the real average hourly earnings rate across all surveyed workers at $10.87 per hour. For the year 2018, real average hourly earnings increased 1.5%, according to the BLS.

The comprehensive BLS report has been created using special methodologies. Individuals looking to calculate their own real wage rate may be better served by adapting the above real income formulas to their own individual situation.

For example, a mid-level manager with a nominal $60,000 per year salary might follow the CPI to calculate his real hourly, weekly, monthly, and annual wage rate. At the end of 2018, the CPI reported an inflation rate of 2.4%. Using the simple formula [Wages / (1 + Inflation Rate) = Real Income], this would result in an approximate real wage rate of $58,594. Calculating real wage rates on an hourly, weekly, and monthly basis can be more complex but still attempted.

The mid-level manager could divide his nominal annual wage by the number of hours, weeks, and months per year with a subsequent adjustment. For a monthly assessment, a $60,000 per year salary would translate to $5,000 in nominal pay per month. Adjusting that by the CPI’s monthly change of -0.01% in December 2018, the $5,000 would have increased its purchasing power to $5,005.

Other takes on the real wage rate might look at the percentage of real to nominal wages or the real vs. nominal wage growth rate. Cost of living indexes can also provide valuable information on real wage vs. nominal wage rate expectations. These indexes are used to make cost of living adjustments (COLA) for workers, insurance plans, retirement plans, and more.

Purchasing Power

Overall, inflation’s effect on wages will affect the purchasing power of an individual consumer. When prices are rising in the marketplace but consumers are getting paid the same wage then a discrepancy is created which leads to an effect on purchasing power. This is why real income decreases when inflation increases and vice versa. When inflation occurs, a consumer must pay more for a fixed quantity of goods or services. Theoretically, this is why savvy investors seek to hold a significant portion of their income in investments with a 2%+ return.

For example, assume a consumer spends approximately $100 per month for a total of $1,200 per year on food during a year when inflation is rising at an annual rate of 1%. Also, assume that the consumer saw no change in their wages. A consumer with a $60,000 annual nominal salary would have lost approximately $595 of purchasing power over a year, or one cent per dollar spent, due to the effects of inflation. In terms of their food purchases, this means the same quantity of food cost them $12 more during the current year compared to the past year. Alternatively, if this consumer isn’t following a strict food budget they will likely spend approximately $101 per month or $1,212 to get the same amount of food they would have bought in the previous year.