What Is Real Income?

What Is Real Income?

Let me explain real income directly: it's the amount of money you or any entity actually make after we've adjusted for inflation. You might hear it called real wage sometimes. I want you to understand why tracking the difference between nominal and real income matters—it's key to grasping how your purchasing power changes over time.

Key Takeaways

Here's what you need to know: real income, or real wage, is simply how much money you earn once inflation is factored out. It stands apart from nominal income, which ignores those adjustments. You should track your real income against nominal to get a clear picture of your buying power. Most calculations for real income use inflation data from the Consumer Price Index (CPI). In theory, when inflation rises, your real income and purchasing power drop by that inflation amount per dollar.

Understanding Real Income

Real income gives you an economic snapshot of your true purchasing power in the market after subtracting inflation. It takes your income and reduces it by the inflation rate per dollar, usually leaving you with less value and weaker spending ability. Remember, deflation can happen too, creating negative inflation, which actually boosts your real income's purchasing power.

This differs from nominal income, which doesn't adjust for shifting prices or living costs. You probably already compare your real and nominal income to understand your buying strength. But keep in mind, real income is just an estimate— the formulas use a wide range of goods that might not match what you actually spend on. Plus, if you don't spend all your nominal income, you might dodge some of real income's impacts.

Real Income Formula

You can calculate real income in a few straightforward ways. Consider these basic formulas: subtract wages times the inflation rate from wages to get real income; or divide wages by (1 plus the inflation rate); or multiply (1 minus the inflation rate) by wages. These integrate various inflation measures, and you can pick the one that fits your situation.

Inflation Rate Measures

All real income formulas can use different inflation gauges. For consumers, three common ones stand out. The Consumer Price Index (CPI) tracks the average cost of a basket of goods and services like food, education, recreation, clothing, transportation, and medical care—the Bureau of Labor Statistics releases these numbers monthly and yearly in the US.

Then there's the Personal Consumption Expenditures (PCE) Price Index, which classifies goods and services a bit differently and has its own methods; the Federal Reserve uses it to assess inflation and guide policy. The GDP Price Index covers everything the US economy produces, excluding imports, making it one of the broadest measures. Generally, these indexes show similar inflation levels, so choose whichever suits your analysis.

Special Considerations for Investing

Many of you invest part of your income in low-risk options that at least match or beat inflation to counter its effects. Look at products offering around 2% or more returns, such as high-yield savings accounts, money market accounts, certificates of deposit, Treasuries, and Treasury Inflation-Protected Securities (TIPS). If you're open to a bit more risk, municipal and corporate bonds can deliver 2% or higher, helping your income grow steadily against inflation.

Real Wage Rates

When you track real wages, several stats come into play. A real wage rate could be your hourly, weekly, or annual pay after inflation adjustment. Expecting a certain real wage is as crucial as planning for nominal wages in your career. The BLS puts out a monthly real earnings report that's useful for monitoring this—the July 2024 report, for instance, showed real average hourly earnings at $11.19 for nonfarm payroll workers, up 0.7% from the year before.

Real Income Formulas in Practice

Take a mid-level manager earning a nominal $60,000 yearly; they might use the CPI with a 2.4% inflation rate. Applying the formula wages over (1 + inflation rate) gives about $58,594 in real terms. For monthly breakdowns, that $60,000 becomes $5,000 nominal per month; with a -0.01% CPI change, purchasing power rises to $5,005.

You could also compare real to nominal wage percentages or growth rates. Cost-of-living indexes help set expectations and adjust for workers, insurance, and retirement plans.

Purchasing Power

Inflation impacts your wages and thus your purchasing power. If prices rise but your pay stays the same, it creates a gap that lowers real income— that's why real income falls with rising inflation and increases with deflation. You end up paying more for the same goods. Smart investors hold income in assets returning 2% or more to maintain constant purchasing power.

For example, if you spend $100 monthly on food ($1,200 yearly) during 1% inflation with unchanged wages, you lose about $600 in purchasing power annually, or one cent per dollar. That means the same food costs $12 more, or you'd spend $101 monthly to keep up.

What Is Meant by Real Income?

Real income is what you earn after inflation adjustments, better showing your wages' purchasing power. High inflation erodes it, while deflation can increase it.

What Is an Example of Real Income?

Say a household earns $100,000 combined. With no inflation or deflation, real income stays $100,000, holding purchasing power steady. But at 5% inflation, it drops to around $95,000 using basic formulas.

Is There a Difference Between Gross Income and Net Income?

Yes—gross income is your earnings before deductions like taxes or healthcare, while net income is your take-home pay after those are subtracted.

The Bottom Line

Real income measures your purchasing power by adjusting nominal income for inflation. It can decrease during inflation, but you can safeguard it with investments yielding above inflation rates.