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What's the Difference Between Nominal and Real?

Real Variables and Nominal Variables Explained

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[Q:] I'm learning economics and I keep hearing the terms nominal and real all the time to describe things like interest rates. What's the difference between nominal and real?

[A:]Great question!

Generally a real variable, such as the real interest rate, is one where the effects of inflation have been factored in. A nominal variable is one where the effects of inflation have not been accounted for. A few examples illustrate the difference:

1. Nominal Interest Rates vs. Real Interest Rates

Suppose we buy a 1 year bond for face value that pays 6% at the end of the year. We pay $100 at the beginning of the year and get $106 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 $100, or we can buy that basket next year and it will cost $103. If we buy the bond with a 6% nominal interest rate for $100, sell it after a year and get $106, buy a basket of goods for $103, we will have $3 left over. So after factoring in inflation, our $100 bond will earn us $3 in income; a real interest rate of 3%. The relationship between the nominal interest rate, inflation, and the real interest rate is described by the Fisher Equation:

Real Interest Rate = Nominal Interest Rate - Inflation

If inflation is positive, which it generally is, then the real interest rate is lower than the nominal interest rate. If we have deflation and the inflation rate is negative, then the real interest rate will be larger.

2. Nominal GDP Growth vs. Real GDP Growth

GDP, or Gross Domestic Product is the value of all the goods and services produced in a country. The Nominal Gross Domestic Product measures the value of all the goods and services produced expressed in current prices. On the other hand, Real Gross Domestic Product measures the value of all the goods and services produced expressed in the prices of some base year. An example:

Suppose in the year 2000, the economy of a country produced $100 billion worth of goods and services based on year 2000 prices. Since we're using 2000 as a basis year, the nominal and real GDP are the same. In the year 2001, the economy produced $110B worth of goods and services based on year 2001 prices. Those same goods and services are instead valued at $105B if year 2000 prices are used. Then:

Year 2000 Nominal GDP = $100B, Real GDP = $100B
Year 2001 Nominal GDP = $110B, Real GDP = $105B
Nominal GDP Growth Rate = 10%
Real GDP Growth Rate = 5%

Once again, if inflation is positive, then the Nominal GDP and Nominal GDP Growth Rate will be less than their nominal counterparts. The difference between Nominal GDP and Real GDP is used to measure inflation in a statistic called The GDP Deflator.

3. Nominal Wages vs. Real Wages

These work in the same way as the nominal interest rate. So if your nominal wage is $50,000 in 2002 and $55,000 in 2003, but the price level has risen by 12%, then your $55,000 in 2003 buys what $49,107 would have in 2002, so your real wage has gone done. You can calculate a real wage in terms of some base year by the following:

Real Wage = Nominal Wage / 1 + % Increase in Prices Since Base Year

Where a 34% increase in prices since the base year is expressed as 0.34.

4. Other Real Variables

Almost all other real variables can be calculated in the manner as Real Wages. The Federal Reserve keeps statistics on items such as the Real Change in Private Inventories, Real Disposable Income, Real Government Expenditures, Real Private Residential Fixed Investment, etc. These are all statistics which account for inflation by using a base year for prices.

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