What is the difference between nominal and real income?

In a nutshell, nominal income is the total amount of money a person earns in a given period of time, while real income is the nominal income adjusted for inflation.

Formula for calculating real income

Formula: Real Income = (Nominal Income / Price Index) x 100

Let's consider a simple numerical example to illustrate the difference between nominal and real income:

Suppose you earn a nominal income of £50,000 in the current year (Year 2).

In the previous year (Year 1), you earned a nominal income of £45,000.

Additionally, let's assume that the price index (a measure of the general price level) increased by 10% from Year 1 to Year 2.

Using this information, we can calculate your real income in Year 2:

1. Calculate the percentage change in the price index: Percentage Change = ((Price Index in Year 2 - Price Index in Year 1) / Price Index in Year 1) x 100 Percentage Change = ((110 - 100) / 100) x 100 = 10%
2. Calculate the real income in Year 2: Real Income in Year 2 = (Nominal Income in Year 2 / Price Index in Year 2) x 100 Real Income in Year 2 = (£50,000 / 110) x 100 ≈ £45,454.55 (rounded to the nearest dollar)

In this example, your nominal income increased from £45,000 in Year 1 to £50,000 in Year 2.

However, after adjusting for the 10% increase in the general price level, your real income in Year 2 is approximately £45,454.55. This means that your purchasing power increased slightly compared to Year 1, despite the nominal income increase.

Real income provides a more accurate reflection of changes in your standard of living by considering the impact of inflation or deflation on your income's purchasing power.