What is Real Income
Real income refers to the income of an individual or group after taking into consideration the effects of inflation on purchasing power. For example, if you receive a 2% salary increase over the previous year and inflation for the year is 1%, then your real income only increases by 1%. Conversely, if you receive a 2% raise in salary and inflation is at 3%, then your real income shrinks by 1%.
BREAKING DOWN Real Income
Real income, also called real wages, refers to the amount of goods and services you can buy today compared to the price of the same goods and services you could have purchased in another time period. For example, if it costs you $2,000 more to purchase the same amount of goods and services (such as food, gas, rent and utilities) this year compared to last year, and your annual income is the same, then your real income has actually decreased by $2,000.
How Real Income Relates to the Consumer Price Index
As real income measures the purchasing power of an individual's wages, analysts often compare it to the Consumer Price Index (CPI). The CPI measures the average cost of a basket of goods including food and beverages, education, recreation, clothing, transportation, and medical care. In the United States, the Bureau of Labor Statics publishes CPI numbers monthly and annually.
How to Calculate Real Income and Purchasing Power
Real income generally compares the purchasing power of income from one year to the cost of goods in another year, and real income can also help you compare wages from two different years, taking inflation or changes to the CPI into account. To compare wages from two different time periods, take the wage from one period and multiply it by the CPI of the other period. Then, divide the product by the CPI from the original time period.
For example, imagine you earned $12 per hour in 2003 and you earned $25 per hour in 2015. If you want to ascertain how your real income has changed over that time period, you need to calculate your 2003 wage in terms of 2015 prices. The CPI for all items in 2003 was 184, while the CPI for 2015 was 236. To continue, multiply $12 (your 2003 wage) by the CPI in 2015. The result is $2,832. Then, divide that number by the CPI from 2003 to get $15.39. This means your 2003 wages are worth $15.39 in 2016, taking inflation into account.
To calculate the change in your purchasing power, subtract the purchasing power of your old wage from the wage to which you are comparing it. In this case, $25 - $15.39 = $9.61. In terms of real income, you earn $9.61 more in 2015 than you did in 2003. To express this change as a percentage, divide the difference by the purchasing power of your old wage. In this case, $9.61/$15.39 indicates your real income increased by 0.624 or 62.4% from 2003 to 2015.