Question

Jimmer's nominal income will go up by 10 percent next year. Inflation is expected to be -2 percent next year. By approximately how much will Jimmer's real income change next year? a. -2 percent. b. 8 percent. c. 10 percent. d. 12 percent.

Short answer

Jimmer's real income will increase by approximately 12 percent (d).

Step-by-step solution

Understanding Real Income

Real income represents the purchasing power of nominal income, taking into account inflation or deflation. It is calculated by adjusting nominal income with the inflation rate.

Calculate the Nominal Income Increase

Jimmer's nominal income is expected to increase by 10 percent next year. This is a straightforward increase in the amount of money he receives before considering inflation.

Account for Inflation

Next year, the inflation rate is expected to be -2 percent, which actually implies deflation. This means that the purchasing power of money will increase next year by 2 percent.

Calculate Real Income Change

To find how much Jimmer's real income changes, add the percentage increase in nominal income (10%) to the real effect of deflation (2%). Thus, the real income change is 10% + 2% = 12%.

Key concepts

Nominal Income

Nominal income is the amount of money an individual earns in current dollars, without taking into account changes in the purchasing power of money due to inflation or deflation. When we talk about someone's salary increase in nominal terms, it simply means the numerical increase in the amount they are paid. For instance, if your salary was $40,000 and it is increased to $44,000, your nominal income has increased by 10%. However, this does not factor in the cost of living adjustments or inflation rates that might affect the true value of that income.

When analyzing income increase, it's crucial to differentiate between nominal and real income growth. While nominal income might show a rise, real income considers the actual value of what you can buy with that money, after taking inflation or deflation into account.

In our example, Jimmer is experiencing a 10% increase in nominal income, which simply means he's getting 10% more in terms of currency. However, this needs to be further analyzed by considering the existing inflation or deflation rate to understand how much more purchasing power he actually gains.

Inflation

Inflation refers to the rate at which the general level of prices for goods and services rises over time, eroding the purchasing power of money. An inflation rate of 3%, for example, means that on average, prices are 3% higher than they were in the prior period, so money buys less.

Inflation diminishes the value of currency as it means goods and services become more expensive with time. This is why during periods of high inflation, even if your nominal income increases, your real income may not necessarily see the same percentage of increase. This is because the higher price levels could negate the additional income, leaving you with little or no actual financial gain in terms of purchasing power.

• In our context, understanding inflation helps in recognizing why Jimmer's nominal income increase does not automatically equate to a real income increase of the same magnitude.

Deflation

Deflation is the opposite of inflation; it occurs when the price levels decrease over time, increasing the real value of money. This means goods and services become cheaper, which effectively increases the purchasing power of consumers.

Contrary to inflation, a deflation rate often indicates a negative number. For example, a deflation rate of -2% means that, on average, prices have decreased by 2%. Deflation can lead to an increased real income because the same amount of money can now purchase more than before. However, prolonged periods of deflation can also indicate a struggling economy and may result in decreased wages and other negative financial impacts.

• In Jimmer's case, the deflation rate of -2% actually boosts his purchasing power, effectively adding to the increase in his real income.

Purchasing Power

Purchasing power refers to the amount of goods and services that can be purchased with a unit of currency. It is a key indicator of the real value of income and is influenced heavily by inflation and deflation.

When inflation is on the rise, purchasing power diminishes unless nominal income increases by the same or a greater rate. Conversely, during deflation, purchasing power increases because goods and services become less expensive.

• For Jimmer, the interplay of a 10% rise in nominal income and a deflation rate of -2% means his purchasing power actually increases by around 12%. This is because the real income increase combines both the nominal rise and the advantages of deflation.

This concept is crucial for both individuals and policymakers to consider when examining economic conditions and making financial decisions.