Q:

What is the difference between nominal income and real income?

A:

Nominal income is the amount of an employee's salary that is paid in cash, whereas real income is the amount the employee receives after accounting for inflation. This means that the nominal income is always the highest of the two figures. Even when an individual has access to more money, her purchasing ability may be low because of inflated prices.

Knowing the difference between nominal income and real income is essential in lending and bond holding. In these situations, borrowers need to charge enough interest to balance out the amount of inflation when the loan fully matures. Without differentiating between real income and nominal income, the borrower actually loses money.

The Federal Reserve is in charge of keeping inflation at a useful and sustainable level. If inflation gets out of control, specific monetary policies are implemented to create balance. Such policies include limiting the amount of money and the amount of credit that is available in the market at any given time. The main goal is to lower the system's level of liquidity. The result of these policies is that they can make credit more expensive to obtain, which can impede economic development and lower prices.

Knowing the difference between real income and nominal income is also important when investing since the end goal is to have both income and purchasing power.


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