Question

Explain how an increase in your nominal income and a decrease in your real income might occur simultaneously. Who loses from inflation? Who gains?

Short answer

Nominal income can increase due to higher wages, while real income decreases if inflation grows faster than wage increases. Those on fixed incomes lose from inflation, while borrowers and some businesses gain.

Step-by-step solution

Introduction to Nominal and Real Income

Nominal income refers to the income received without adjusting for inflation, while real income accounts for the purchasing power, reflecting the amount of goods and services that can be bought with that income. When inflation occurs, prices of goods and services increase. If your salary increases at a slower rate than inflation, your real income decreases.

Analyzing the Nominal Income Increase

Let's say your salary increases from $50,000 to $53,000. This means your nominal income has increased by $3,000, or 6%. This increase is simply the amount earned in currency terms without considering prices.

Understanding the Effect of Inflation on Real Income

Assume that inflation in the economy is at 10% during the same period. This means that the cost of living has increased significantly as prices for goods and services have gone up by 10%. Even though you now earn $53,000, the overall increase in prices outpaces your salary growth, effectively reducing your purchasing power.

Calculating Effective Purchasing Power

Convert your new salary to real income by adjusting for inflation. Real income = Nominal Income ÷ (1 + Inflation Rate). Given your new salary is $53,000 and inflation is 10%, the calculation would be: Real income = $53,000 ÷ (1 + 0.10) = $53,000 ÷ 1.10 ≈ $48,182. Your real income has effectively decreased compared to your previous salary of $50,000.

Identifying Who Loses From Inflation

During inflation, people with fixed salaries or incomes not adjusted for inflation, like retirees on a fixed pension, lose because their purchasing power decreases. Even if they receive cost-of-living adjustments, if these are not keeping pace with inflation, their purchasing power still falls.

Identifying Who Gains From Inflation

Inflation can benefit borrowers because they repay their debts with money that is worth less than when they initially borrowed it. Businesses that can increase prices faster than their costs rise, or individuals with significant investments in inflation-hedged assets, like real estate, can also benefit. In addition, wage earners whose salaries increase faster than inflation gain.

Key concepts

Nominal Income

Nominal income is the total amount of money earned over a certain period without adjusting for inflation. For example, if you earn $50,000 a year and receive a raise that brings your income to $53,000, your nominal income has increased by $3,000 or 6%. This figure is straightforward and easy to calculate; however, it does not consider changes in the price of goods and services.
While a nominal income increase might seem beneficial, it can be misleading. If prices rise significantly due to inflation, your increased salary might not go as far as it did before. This highlights the importance of understanding not just the amount of money earned, but also the purchasing power it gives you.

Real Income

Real income gives a true picture of how much you can purchase with your earnings. It adjusts your nominal income to account for inflation, reflecting its actual purchasing power. When inflation is present, calculating real income helps clarify if your earnings can buy more, the same, or fewer goods and services compared to a previous period.
To calculate real income, you need to take your nominal income and adjust it for inflation:

• Real Income = Nominal Income ÷ (1 + Inflation Rate)

If you earn $53,000 and the inflation rate is 10%, the real income would be approximately $48,182. This indicates you can buy less than before compared to your previous $50,000 salary if prices had remained stable. Real income decreases when inflation outpaces the growth of your nominal income.

Purchasing Power

Purchasing power refers to the quantity of goods or services that one can buy with a given amount of money. When inflation increases, purchasing power declines if the nominal income does not rise at the same pace as prices.
This means that even if you receive a pay raise, your ability to purchase items could be lessened because your income's real value has diminished. For instance, with a 10% increase in prices due to inflation, a salary increase of only 6% results in lower purchasing power because expenses grow faster than income. Understanding purchasing power is crucial for managing finances, especially during periods of high inflation.

Fixed Income

Individuals with fixed income, such as retirees or those on a fixed salary, face significant challenges during inflationary periods. Because their income does not automatically rise with prices, their purchasing power decreases.

• Those relying on fixed pensions or social security benefits may suffer a decline in living standards.
• Many fixed incomes are not adjusted quickly enough to keep up with inflation, resulting in reduced ability to purchase necessities.

In some cases, "cost-of-living" adjustments are intended to counteract inflation, but these are not always sufficient to completely offset the impact of rising prices. Protecting against inflation often requires additional strategies, such as investments in assets that hedge against inflation.