What Is Real Income?
Real income is how much money an individual or entity makes after accounting for inflation and 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.
- Real income, also known as real wage, is how much money an individual or entity makes after adjusting for inflation.
- Real income differs from nominal income, which has no such adjustments.
- Individuals often closely track their nominal vs. real income to have the best understanding of their purchasing power.
- Most real income calculations are based on inflation reported by the Consumer Price Index (CPI).
- Theoretically, when inflation is rising, real income and purchasing power fall by the amount of inflation on a per-dollar basis.
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. It subtracts an economic inflation rate per dollar from an individual’s income, typically resulting in a lower value and decreased spending power.
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.
Real income differs from nominal income, which is not adjusted to account for fluctuating prices and living costs. Individuals often closely track their nominal vs. real income to have the best understanding of their purchasing power.
Overall, real income is only an estimate of an individual’s purchasing power 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 the real income’s effects.
Real Income Formula
There are several ways to calculate real income. Three basic real income formulas include the following:
- Wages - (wages * inflation rate) = real income
- Wages / (1 + Inflation Rate) = real income
- (1 – Inflation Rate) * Wages = real income
Inflation Rate Measures
All real income/real wage formulas can integrate one of several inflation measures. Three of the most popular inflation measures for consumers include:
Consumer Price Index (CPI)
The consumer price index (CPI) CPI measures the average cost of a specific basket of goods and services, including food and beverages, education, recreation, clothing, transportation, and medical care. In the United States, the Bureau of Labor Statistics (BLS) publishes CPI numbers monthly and annually.
Personal Consumption Expenditure Price Index
The Personal Consumption Expenditure (PCE) Price Index is a second comparable consumer price index. It includes slightly different classifications for goods and services and 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.
GDP Price Index (Deflator)
The GDP Price Index is one of the broadest measures of inflation since it considers everything produced by the U.S. economy, excluding imports.
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.
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 to mitigate the effects of inflation on their income.
Several risk-free investments 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 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 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.
Having an expectation for a real wage rate can be just as important as a career expectation for a nominal wage rate.
The BLS publishes a monthly real earnings report, which can be helpful in keeping tabs on real wage rates. The “January 2021 Real Earnings” report, for example, shows the real average hourly earnings rate across all surveyed workers on private nonfarm payrolls at $11.43 per hour—a 4% increase on January 2020.
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 situations.
Real Income Formulas
For example, a mid-level manager with a nominal $60,000 per year salary might follow the CPI to calculate their real hourly, weekly, monthly, and annual wage rate. Suppose 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—relative to the period in which the $60,000 was calculated.
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, let's say of -0.01%, 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.
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. In that case, with inflation at 2% they would be able to maintain their purchasing power at a constant level.
For instance, 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 $600 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.