Suppose you’ll have an annual nominal income of $55,000 for each of the next 3 years, and the inflation rate is 5 percent per year.
(Hint: Use the following formula): I0 / (1 + r)t where I0 is the nominal income, r is the inflation rate and t is the number of years.
Instructions: Enter your responses rounded to two decimal places.
Find the real value of your $55,000 salary for each of the next 3 years.
The time value of money, or value of money over time is given by the following equation:
Future Value, FV = Present value/(1+r)^t
where, r is rate of inflation (as fraction) and t is time interval (in years, if rate of inflation is in years).
Here, present value = nominal salary = $55,000, rate of inflation, r = 5% or 0.05
For time = 1 year, FV = 55,000 / ( 1 + 0.05)^1 = $52,380.95
For time = 2 years, FV = 55,000 / ( 1 + 0.05)^2 = $49,886.62
For time = 3 years, FV = 55,000 / ( 1 + 0.05)^3 = $47,511.07
Thus, the real value of a nominal salary of $55,000 falls down to $52,380.95 after one year, to $49,886.62 after 2 years and to $47,511.07 after three years. That is the reason people need increments every year to maintain their salaries at the original level.
Hope this helps.