Suppose that a person's nominal income rises from $10,000 to $12,000 and the consumer price index rises from 100 to 105. The person's real income will:

The CPI a measure of the avreage price of a large basket of retail goods consumed by a typical consumer. So the CPI is useful to determine the rate of inflation which is the percentage change in the CPI from one year (base) time to another (current). In our question, the rate of inflation is 5% i.e (105-100)/100

Nominal income is amount of income earned in current price terms. This represents the amount of quantity of dollars earn in today's terms. It does not give account of how much the consumption potential of the worker would increase if the nominal income increase.

Real income on the other hand is the nominal income adjusted for inflation. It represents amount of purchasing power possessed by the holder of the nominal dollars. It is possible to have an icrease in nominal income without a corresponding increase in real income due to the impact of inflation.

Real income, Nominal income and Inflation

Real income is different from nominal income because of inflation. Real income can be calculated by expressing the nominal income in constant price terms. For example, the worker in our question now earns $12,000 now, but there has been an inflation of 5%. So the $12,000 now won't help him purchase as much at he would a year a ago. So we can work out how much the the current (nominal) income is worth in terms of the prices a year ago- the base year. This is done as follows:

Real income= (CPI base year/ CPI current year) * Nominal income in current year.

Real income= (100/105)* 12,000 = $11,428.57

The real income has only increased by $1,428.57 i.e 14,428.57- 10,000

The change in nominal income is 20% (12,000-10,000)/10,000 while the change in real income is only 14.3%. The difference between the change in real income and nominal income is simply because of inflation.