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Real Income: Definition, Effect & Formula

Instructor: Tara Schofield
How can you make the same amount and have less money? This lesson will discuss real income and explain the impact inflation has on buying power, both good and bad.

What is Real Income?

Real income is the amount of money you have and the buying power of that money, based on the rate of inflation. Real income can go up or down based on whether the inflation rate is going up or down. When real income goes up, a person's purchasing power increases. Likewise, when real income goes down, purchasing power decreases.

Real income has an impact on individuals, groups, businesses, organizations, and even countries. Inflation impacts everyone who is buying or selling items. There is an opposite, or inverse, relationship between income and inflation. When income levels remain constant, an increase in inflation causes a decrease in purchasing power (the cost of things go up and income stays the same). Again, when income levels remain constant, a decrease in inflation causes an increase in purchasing power. When this happens, the cost of items is going down and more items can be purchased with the same amount of money.

Examples of Real Income

Let's look at a couple of examples. If you earned $50,000 last year and will earn $50,000 this year, you will have the same amount of income. However, if inflation changes, the buying power you used to have will be affected. If inflation goes up 2%, the cost of goods essentially goes up 2% as well. Your real income drops, not because your actual take home income changes, but because the amount you can purchase with $50,000 is less this year than it was last year.

On the flip side, if inflation goes down 2% and your income remains the same, you can buy more with the same amount of money. Your real income goes up because you can buy more with $50,000 this year than you could last year.

The impact of inflation can drastically affect real income, especially if you look at annual purchases. Though you may not have purchased anything more this year than you did the year before, you may find yourself spending $4,000 more. Since your real income has dropped, your money won't go as far as it did previously.

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