Nominal Income refers to the income that is paid or earned by an individual. Real income is referred to as the money that an individual earns after it has been adjusted for inflation. Basically the main difference between the two is that nominal income is what you have earned in reality as opposed to your real income which has been adjusted because of inflations. The Money Illusion is a very good example of the difference between these two concepts. In the Money Illusion, people mistake nominal income or variables for real income or variables.
The term Money Illusion was first coined by Keynes, and it shows that people do tend to think in this way as supported by empirical evidence. When you think about it, it is easier for a everyday person, one who doesn’t know as much about economics, to relate to the concept of the Money Illusion. Everyday people are more concerned with the money that the get and they don’t take the time to think about inflation and how that is going to affect their income (Miller, 1997). Purchasing Power is defined as the amount of value of a good or service compared to the amount paid with a currency.
As such, purchasing power has to do with both the nominal income and the real income of a economy. As Adam Smith has been noted to say one a person has money they have the ability to “command” other people to work for them. This is seen throughout history, the pharaohs of Egypt or even the captains of industry in the United States have shown this to be true. Purchasing power is to some extent the power over other people who are willing to trade their labors or products for the money that will be paid.
The way that purchasing power relates to nominal income is that if the nominal income of the person stays the same but the price level of the goods they buy increases then the purchasing power of that income falls. The interesting thing about purchasing power is in how it relates to real income. As noted earlier, real income is the income you make after it has been adjusted by inflation. Where purchasing power is concerned, inflation doesn’t always imply a falling purchasing power of a person’s real income.
A person’s income may rise faster then inflation does and as such real income is not as affected as nominal income is by purchasing power (Miller, 1997) The Inflation gap is the amount by which the real gross domestic product (the real GDP) exceeds the potential GDP. The real GDP is adjusted for inflation and measures the aggregate output in a country’s income in a given year. The inflation gap then concerns itself more about the real income of a country as measured by the real GDP.
The potential GDP is the quantity of real GDP when the country’s economy is at full-employment. When the country’s economy has an initial increase in aggregate demand that produces inflation and the real GDP increases, the price level and the and real GDP are determine at the point where the new aggregate demand and short-run aggregate supply meet. The gap that is created between the real GDP and the potential GDP is the consequence of the rise in inflation, hence the reason that it is called the inflation gap (Miller, 1997).
The Recession gap is the amount by which the aggregate expenditures schedule must shift upwards to increase the real GDP to its full employment, noninflationary level. The recession gap exists when production is less then full employment and unemployment is often likely to result. When looking at the recession gap, real instead of nominal income is what is at the center of this idea. The real GDP, which is concerned with the real income and not the nominal income of a country, is what is measured as indication of this concept (Miller, 1997).
6. The Gross Domestic Product (GDP) is one of several measures of national income and output for a given country’s economy. It is defined as the total market value of all final goods and services produced within the country in a given times period, which is generally one calendar year. The GDP is also often considered the sum value added at every stage of production of all final goods and services produced within the country for the given time period and it is a given money value (Miller, 1997).
Disposable Income is defined as the gross income minus income tax on that income. It is also used commonly to denote discretionary income and as such often people think of the two as going hand in hand. Discretionary income is the income after subtracting taxes and the normal expense of living (such as buying food or paying rent) to maintain a certain standard of living. As such, it is the amount of a person’s income that is available for spending on things after the essentials of food, clothing and shelter have been taken care of (Miller, 1997).
Personal Consumption Expenditures the purchases of currently produced goods and services out of the income that a person makes, out of the person’s savings, or income that they have burrowed. Consumption expenditures refers to the part of the disposable income that does not go into a savings account. In the United States, Personal Consumption Expenditures are also referred to as household consumption expenditures and it is determined by the consumption function, in particular the marginal propensity to consume.
This measure is part of the aggregate demand and it can be defined as the selection, adoption, use, disposal, and recycling of goods and services (Miller, 1997). Base year is a unit of time, or a period of a year, that is used as a reference in constructing an index number. In economics it is used to look at how things such as the real GDP or other measures have influenced the financial stability of a given country. In general it is the period of on fiscal year over which measurements of a country’s economy are taken (Miller, 1997).
Entitlements are government programs that provide individuals with person financial benefits to which an indefinite number of potential beneficiaries have a legal right whenever they meet eligibility conditions that are specified by the standing law that authorizes the program. The beneficiaries of those programs are average everyday citizens, but sometimes organizations such as business corporations, local governments or even political parties may have similar special “entitlements” under certain kinds of programs.
Examples of entitlements are the social security system, food stamps, and Medicare (Miller, 1997). Government deficits are excesses of a country’s government spending over its revenues. Many economists believe that federal deficits are what lead to inflation in a given country. Basically, the government spends more money then it takes in which leads to the deficit. When deficit has accumulated over years it is referred to as government debt. The government tries to remedy the debt by dedicating part of its spending to the payment of the debt by issuing new bonds.
In other words a fiscal deficit leads to an increase in the government’s debt to others (Miller, 1997). Inflation is the rate at which the general level of prices for goods and services is rising and the purchasing power of consumer is subsequently falling over a period of time. As the general price level rises in a country, each unit of their currency buys less and less goods and services which cause the purchasing power of the consumer to be lessened (Miller 1997).
Excess inventories are the result of bad management of stock demand and they are associated with loss of revenue owing to additional storage space taken. Excess inventories can cause the loss of millions of dollars and adversely affect the economy of a given country. Take for example the accumulation of too much fresh fruit without buyers for it. As the market waits for consumers to buy the fruit, the freshness of the fruit deteriorates and after a set time can no longer be sold, thus costing the company who was selling it to lose millions of dollars because their inventory exceeded the demand for it (Miller 1997).