Nominal Income vs. Real Income

submitted by jwithrow.US Dollar Purchasing Power

Most of us understand that inflation is a given in our world today but not too many of us think about how inflation affects our income. We tend to think of our income in nominal terms rather than in real terms because we can explicitly see the nominal picture whereas we must do a little analysis in order to see the real picture.

Nominal income is our income defined only by its dollar amount. While this just seems like common sense, there is an inherent problem with this view given our current monetary system. You can start to see the flaw with the nominal view of income when you compare it over periods of time.

If our income was $48,000 last year and we make $50,000 this year then nominally our income is 4% higher this year and we are pretty happy about that.

But if we think of income in real terms then we may not be so happy. Real income is income defined by its purchasing power; basically it is nominal income adjusted for inflation.

So, using the same example from above, if the inflation rate (hypothetically) between this year and last was 5% then our income actually decreased by 1% in real terms. We can buy 1% less this year then we could last year. So we actually earned less money in terms of purchasing power this year even though our paychecks were nominally bigger.

What a sucker we are, right?

Simply put, real income measures purchasing power which becomes relevant when comparing the value of the dollar to goods and services. This is why the Austrian School of Economics views inflation as an insidious tax. If nominal income kept pace with the inflation rate then inflation would not be quite so deceptive. But certain types of income, namely wages and fixed income, very rarely keep up with the inflation rate.

Now, wages do tend to do a pretty good job of keeping up with the Consumer Price Index (CPI), but this index has been adjusted several times to heavily disregard food and fuel price increases. Coincidentally, Social Security promises periodic cost of living increases tied to the CPI – do you think that this has anything to do with the CPI calculation changes? If you measure inflation without discounting food and fuel prices (see then it becomes very clear that wages typically do not keep up with inflation.

It is impossible to gauge our true personal financial situation without a solid understanding of real income.

This concept also exposes the retirement folly pushed by the financial services industry that suggests we all must reach a magic “number” in terms of dollars saved for retirement so that we can securely live off of the income generated by this number during our retirement years. If we think in terms of real income and purchasing power then it becomes impossible to pinpoint a specific number; that magic number is like the proverbial carrot on a string.

So, we would suggest that the only way to truly take control of our own financial destiny is to think in real terms and to recognize the nominal view of money for the illusion that it is.