Real Income

The first place to apply that deflator is your own paycheck. Personal incomes rarely keep up in times of high inflation. Your real income (income measured in constant prices relative to some base time period) is the more important number: it reflects the actual buying power of the nominal income you have to spend. Rising nominal income during times of inflation creates the illusion that you are making more money.

To compare income across years you deflate it to a chosen base year using the ratio of price indices:

The base year is your choice; “today’s dollars” simply means using the current index as the base. The often-quoted shortcut $\text{Nominal}÷\text{Index}\times 100$ is this same formula with the base year’s index hard-coded at 100, which works only when the index is stated on that convention.

Why this matters at the negotiating table. Suppose you earned $200,000 three years ago and you now earn $220,000. That is a 10% raise, and it feels like progress. If CPI rose from 300 to 330 over the same period:

You earn exactly what you earned three years ago. Your real income change is zero. You did not get three raises; you got three inflation adjustments, and if any of those years’ increases came in below inflation, you took a pay cut while being congratulated for it.

The general test for whether a raise is real:

where $\pi$ is the economists’ standard symbol for the inflation rate (no relation to the geometric constant — this book uses it throughout). A 4% raise against 2.5% inflation is a 1.5% real raise. A 2% raise against 2.5% inflation is a pay cut. Do this arithmetic before the compensation conversation, not after, and note that the most reliable way to secure a genuinely large real increase is changing employers — internal raise budgets are typically set as a pool pegged near inflation, while external offers are set by the market for your replacement.