Assume that nominal income is $35,000 and the price index is 1.20 in year 1. In year 2, nominal income rises to $38,000 and the price index rises to 1.25. What was the percentage change in real income from year 1 to year 2? What was the absolute amount of increase in real income? Make your calculations of the percentage change in real income and the absolute change in real income using the approximation formula and using the more precise method with index numbers.
What will be an ideal response?
First, calculate the percentage change by the approximation formula. Nominal income has increased by 8.6% [($3000/$35,000) ? 100]. The price level has increased by 4.2% [(.05/1.20) ? 100]. The percentage change in real income was approximately 4.4% (8.6% ? 4.2%). To calculate the amount of the absolute increase in real income, multiply 4.4% times $35,000, which equals $1540.
The more precise calculation would use index numbers. Real income in year 1 was $29,166.7 ($35,000/1.20). Real income in year 2 was $30,400 ($38,000/1.25). The absolute change in real income was $1233.3. The percentage change in real income was 4.2% [($1233/$29,166) ? 100].
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