Question 8.1: Real-Dollar Purchasing Power of Your Salary Suppose that you...
Real-Dollar Purchasing Power of Your Salary
Suppose that your salary is $45,000 in year one, will increase at 4% per year through year four, and is expressed in actual dollars as follows:
| End of Year, k | Salary (A$) |
| 1 | 45,000 |
| 2 | 46,800 |
| 3 | 48,672 |
| 4 | 50,619 |
If the general price inflation rate (f) is expected to average 6% per year, what is the real-dollar equivalent of these actual-dollar salary amounts? Assume that the base time period is year one (b = 1) .
By using Equation (8-2 : (R\$ )_{k,j}= (A\$ )_{k,j}\left(\frac{1}{1+f} \right) ^{k-b} (A$)_{k, j}(P/F, f%, k − b)), we see that the real-dollar salary equivalents are readily calculated relative to the base time period, b = 1:
| Year | Salary (R$, b = 1) |
| 1 | 45,000(P/F, 6%, 0) = 45,000 |
| 2 | 46,800(P/F, 6%, 1) = 44,151 |
| 3 | 48,672(P/F, 6%, 2) = 43,318 |
| 4 | 50,619(P/F, 6%, 3) = 42,500 |
In year one (the designated base time period for the analysis), the annual salary in actual dollars remained unchanged when converted to real dollars. This illustrates an important point: In the base time period (b), the purchasing power of an actual dollar and a real dollar is the same; that is, R$_{b, j} = A$_{b, j} . This example also illustrates the results when the actual annual rate of increase in salary (4% in this example) is less than the general price inflation rate (f). As you can see, the actual-dollar salary cash flow shows some increase, but a decrease in the real dollar salary cash flow occurs (and thus a decrease in total market purchasing power). This is the situation when people say their salary increases have not kept pace with market inflation.