As a business owner, you want to pay your employees fairly so they feel valued and do their best work. For this reason, it's important to make the difference between nominal and real wages. Even though both terms refer to the compensation received by employees, they have unique characteristics. Each type of wage is influenced by different factors, such as inflation, tax rates and work conditions.

What Are Real Wages?

Wages paid to U.S. workers are expected to increase by 1 percent in 2018. Experts predict that Argentina will experience a real salary growth of 7.3 percent. India, Vietnam, Thailand and Ecuador will see an increase of 4.4 percent to 4.7 percent. This growth is largely determined by improvements in labor productivity.

Real wages depend on inflation. If they rise more quickly than inflation, employees will earn more and have higher purchasing power. When inflation increases faster than real wages, living costs go up and purchasing power declines.

When you're running a business, it's important to have a thorough understanding of the nominal vs real wage. Employees care about the real wage because it's what reflects the true cost of labor. It also shows how living standards have changed. Basically, real wages determine the amount of goods and services a salary can buy. They depend on a number of factors, such as:

  •        Purchasing power
  •        Inflation
  •        Subsidiary earnings
  •        Work conditions
  •        Regularity or irregularity of employment
  •        Extra work without payment
  •        Future prospects

For example, a real wage of $1,000 per month in a small town may provide a more comfortable life and allow employees to get more for their money than a similar amount in a big city. If inflation is 3 percent and wages increase by 2 percent, the real wage will be -1 percent. In this case, purchasing power will drop despite real wage growth. Employees will afford fewer products and services despite earning more.

What's the Difference between Nominal and Real Wages?

Inflation is what makes the difference between nominal and real wages. The amount of money received by a worker does not depend on the inflation rate in the market. This is called a nominal wage. It refers to the payments made to employees in money form only, which is the official nominal wage definition.

Nominal wages or money wages are largely based on the organization’s payment policy and government regulations. They don't reflect the market conditions and are not derived from any formula. Their sole purpose is to compensate for the time and effort put into work. For example, if an employee receives $20 per hour or $3,200 per month, then that is their nominal wage.

Under certain circumstances, money wages can increase, but the purchasing power will drop or remain the same. For instance, if an employee made $2,000 five years ago and earns $2,700 today, their nominal wage is higher now. However, he or she cannot purchase as many products with $2,700 today as he or she could with $2,000 five years ago because of the increase in prices.

The money wage rate does not reflect an employee's real earnings. Additionally, it only considers the current point in time, not the market conditions or economic growth experienced over the years. Real wages, by comparison, take these factors into account and determine purchasing power.