Getting Real Suppose a student gets an allowance of $10.00 in year 1, $10.00 in year 2, and $11.00 in year 3. What happens to her ability to buy goods if the table below measures her cost of living? To answer this, we can compute how many market baskets she could buy with her income. She can buy two market baskets in the first year, only 1.82 baskets in the second, and 1.83 in the third. From these numbers we can see that her ability to buy goods declined from year 1 to year 2, and then rose very slightly from year 2 to year 3. As this example suggests, an important use of price indexes is to measure what happens to the purchasing power of income. COMPUTING A PRICE INDEX (repeated) AMOUNT PRICE YEAR 1 PRICE YEAR 2 PRICE YEAR 3 Hamburgers 3 .75 .70 .90 Colas 8 cans .25 .30 .30 Gasoline 1 gallon .75 1.00 .90 Cost of the Market Basket 5.00 5.50 6.00 Price Index 100.00 110.00 120.00 An alternative way to measure changes in purchasing power, the one economists use, is to divide her income in each year by the price index of that year and then multiply by 100. This procedure gives us $10.00 for the first year, $9.09 for the second, and $9.17 for the third. This computation gives us real income. It says that the $11.00 in the third year bought only as much as $9.17 would have bought in the first year. An income of $9.17 with the prices of the first year had the same purchasing power as $11.00 with prices of the third year. Again, we can see that her ability to buy goods declined sharply from the first year to the second, and then rose slightly from the second to the third. Nominal income is also called current-dollar income; real income is also called constant-dollar income. The equation used to find real income is similar to the equation used to find a price index: Price Index = ((Nominal Income)/(Real Income)) x 100. If we know two of the three items in the equation above, we can find the third with simple algebra. For example, if a person earned $8000 when the price index was 120 and $12000 when the price index had risen to 140, his real income would have risen from $6666.67 to $8571.43. His nominal income has increased by 50%, but his real income has increased only 28.6%. Copyright Robert Schenk