Real and nominal value

In economics, the idea of nominal value looks at the amount of money something is worth without considering changes in prices over time. This is like checking the price tag on a toy today and saying, “It costs $10.”

Real value, on the other hand, looks at what that money can actually buy. It takes into account how prices change, called inflation, to show the true worth of something. For example, if a toy cost $10 ten years ago and prices have gone up, the real value of that toy today might be less, even if it still costs $10.

Understanding the difference helps us see how much things truly grow or shrink over time. In big economic studies, like measuring how well a country is doing, economists use real gross domestic product real gross domestic product to remove the effect of inflation. This lets them see the real growth of an economy, not just the numbers that include rising prices. If we only looked at nominal GDP, it would include inflation and seem bigger, but it might not show the true growth.

Commodity bundles, price indices and inflation

A commodity bundle is a list of goods. It helps us understand the value of things over time by showing what those goods cost and how many there are. The nominal value of this bundle is just the total cost of all the goods at any given time.

A price index tells us how the price of this bundle changes over time or in different places. We often compare prices to a base or reference date. For example, if we choose the end of 1992 as our base date, the price index starts at 100. As prices change, the index goes up or down from this number. If prices go up by one percent after the base date, the index becomes 101.

The inflation rate measures how much prices have changed between two points in time. It shows the percentage increase or decrease in the price index from one time to the next.

Real value

Comparison of real and nominal gas prices 1996 to 2016, illustrating the formula for conversion. Here the base year is 2016.

The nominal value of things can change over time. But the real value of a group of goods stays the same overall. Even though individual items may cost more or less than each other, the total value of all goods together doesn’t change.

We can use a special number called a price index to find the real value. This helps us see how much something is worth compared to a set time in the past. By doing this, we can see the true value of things like wages or how much is made, without the changes in prices confusing us.

Real growth rate

The real growth rate shows how much a value has changed in terms of buying power over time. It looks at how much more or less we can buy with that value after considering changes in prices, called inflation.

The real growth rate is found by comparing the value of something now to its value in the past, adjusting for how prices have changed. This helps us understand true growth, not just changes in money amounts.

Real wages and real gross domestic products

The bundle of goods used to measure the consumer price index (CPI) is applicable to consumers. For wage earners as consumers, an appropriate way to measure real wages (the buying power of wages) is to divide the nominal wage (after-tax) by the growth factor in the CPI. Gross domestic product (GDP) is a measure of the total output of goods and services in a country. Nominal GDP in a particular period reflects the prices that were current at the time, whereas real GDP compensates for inflation. In the U.S. National Income and Product Accounts, nominal GDP is called GDP in current dollars and real GDP is called GDP in [base-year] dollars.

Example

If for years 1 and 2 (possibly a span of 20 years apart), the nominal wage and price level P of goods are respectively

nominal wage rate: $10 in year 1 and $16 in year 2

price level: 1.00 in year 1 and 1.333 in year 2,

then real wages using year 1 as the base year are respectively:

$10 (= $10/1.00) in year 1 and $12 (= $16/1.333) in year 2.

The real wage each year measures the buying power of the hourly wage in common terms. In this example, the real wage rate increased by 20 percent, meaning that an hour's wage would buy 20% more goods in year 2 compared with year 1.

Real interest rates

Main article: Real interest rate

When we talk about how much money grows over time, we can look at it in two ways: the actual amount of money, called nominal value, and the value after considering changes in prices, called real value.

The real interest rate shows how much a financial asset, like money in a bank, grows after taking inflation into account. It is roughly the nominal interest rate minus the inflation rate. This helps us understand the true growth of our money over time.

Cross-sectional comparison

We can compare values from different places by looking at both the amount of goods made and their prices. When prices change in different areas, we can adjust the total value of goods to use the same prices everywhere. This helps us see how much different regions are really producing, not just what it looks like with different prices.

Main article: time-series
Main articles: cross-sectional data