Is your salary really increasing?
If your Salary is Rs 50,000 in 2002 and Rs 55,000 in 2003...does it mean that your salary has increased? Nominally..YES, but
might not be in REAL terms.
To be more clear...If your Salary is Rs 50,000 in 2002 and Rs 55,000 in 2003but the price level has risen by 12%(inflation) then your Rs 55,000 in 2003 buys what Rs 49,107 would have in 2002, so your real salary has gone done.
Eg: YOu could have bought a bike with Rs 50,000 in 2002 but in 2003 the bike rate has gone up to 62,000...which you can not
buy with your 55,000 Rs salary. Meaning ...your salary has actually gone down.
Similary...think of this point when you are saving money in a bank or investing money in some bonds.
You have fixed deposited 50,000 in a bank for 1yr. Bank promised to pay you 3% intrest. But if the inflation is 4% that year...the bank is actually taking away one percent of your money. Got me?
Suppose we buy a 1 year bond for face value that pays 6% at the end of the year. We pay Rs100 at the beginning of the year and get Rs106 at the end of the year. Thus the bond pays an interest rate of 6%. This 6% is the nominal interest rate, as we have not accounted for inflation. Whenever people speak of the interest rate they're talking about the nominal interest rate, unless they state otherwise.
Now suppose the inflation rate is 3% for that year. We can buy a basket of goods today and it will cost Rs100, or we can buy that basket next year and it will cost Rs 103. If we buy the bond with a 6% nominal interest rate for Rs100, sell it after a year and get Rs106, buy a basket of goods for Rs103, we will have Rs 3 left over. So after factoring in inflation, our Rs100 bond will earn us Rs 3 in income; a real interest rate of 3%.
You can calculate a real salary in terms of some base year by the following: Real salary = Nominal salary / 1 + % Increase in Prices since Base Year
Where a 34% increase in prices since the base year is expressed as 0.34.