Many societies strive to improve the well-being of their members by increasing incomes. The statement “Canadian household incomes have increased,” may give an immediate impression that these households are better off. However, this may not necessarily be the case if nominal income is considered because inflation may completely erode any nominal income gains.
Nominal income is income that is not adjusted for changes in purchasing power, the amount of goods or services that one can afford with the income, owing to inflation. Adjusting nominal income for inflation is important because inflation decreases the amount of goods or services that one can afford with a given amount of nominal income. To see how inflation can erode nominal income gains, suppose that nominal income rises by 50 percent this year over last year. An individual is, in fact, better (worse) off if prices rise by less (more) than 50 percent over the same period, since the amount of goods or services that person can afford with the higher nominal income is more (less). Since nominal income is not adjusted for changes in the cost of living due to inflation, it is not a fully satisfactory measure of well-being. Fortunately, nominal incomes (e.g., wages, pensions) can be successfully adjusted to avoid loss in purchasing power due to inflation, provided that inflation is correctly anticipated.
Problems may arise when making international comparisons of nominal incomes. Suppose that the nominal income of a U.S. resident rises by $1 and that of a Ugandan resident also rises by the same amount. If the amount of goods or services that one can afford with the $1 is higher in Uganda than in the United States, then the $1 received in Uganda should be considered to be the higher income. Therefore, for international comparisons of nominal incomes (and other variables expressed in monetary terms), adjustments for purchasing power differences among countries are necessary. It is therefore not surprising that, for poverty comparison purposes, the World Bank (2005) reports the percentage of the population living on less than $1 a day after adjusting for purchasing power parity (PPP).
Even if nominal income is successfully adjusted for inflation (or PPP), some philosophical issues exist surrounding the appropriateness of nominal income as a measure of well-being. For example, according to the Capabilities Approach attributed to Amartya Sen, winner of the 1998 Nobel Prize in economics, functional capabilities (i.e., what a person can do or can be) are more important than income improvements.
The concept of nominal income is also commonly used in national income accounting to refer to nominal gross domestic product (GDP), the nominal value of all goods and services produced within a country’s borders during a given time period. In evaluating nominal GDP, the output for a given year is evaluated using that year’s prices. The practice of using nominal income to refer to nominal GDP is reflected in the vast literature on nominal income targeting, including the work of Henrik Jensen.
SEE ALSO Gross Domestic Product; Gross National Income; Inflation; Money Illusion; Nominal Wages; Real Income
Jensen, Henrik. 2002. Targeting Nominal Income Growth or Inflation? American Economic Review 92 (4): 928–956.
Sen, Amartya. 1985. Commodities and Capabilities. Amsterdam, New York: North-Holland.