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Real vs. nominal in economics

From Academic Kids

In economics, the distinction between nominal and real numbers is often made. It corresponds to the distinction between money and inflation-corrected numbers.

Nominal numbers - such as nominal wages, interest rates and gross domestic product (GDP) - refer to amounts that are paid or earned in money terms. A paycheck shows money wage and a car loan agreement indicates the nominal interest rate. Nominal GDP refers to the amount of money spent to buy the production of a country.

Real numbers - real wages, interest rates, and GDP - are corrected for the effects of inflation. They indicate the value of these numbers in terms of the purchasing power of wages, interest, or total production. That is, they try to estimate how many goods and services a wage, an interest payment, or total domestic income will buy.

  • real wage is the ratio of the nominal wage to some measure of the price level (for example, the consumer price index).
  • the real interest rate is different, since it must be adjusted for the effects of inflation over time on money that is lent. A first approximation for the real interest rate equals the nominal interest rate minus the rate of inflation over the period of the loan.
    • The expected real interest rate is the nominal interest rate minus the inflation rate expected over the term of the loan.
    • The realized (ex post) real interest rate has the actual inflation rate subtracted from the nominal interest rate.
    • In the real world, the real interest rate can only be seen in debt instruments such as Treasury Inflation Protected Instruments, which establishes a real interest rate before-hand, with no guessing involved on the part of the investor.
  • the calculation of real gross domestic product is also different from the real wage. As a first approximation, real GDP is calculated by adding up all the goods and services in the economy produced during a year using the prices that prevailed during the base year. Thus the 2004 GDP in 1982 prices (the inflation-corrected GDP) would add up all the 2004 products using the prices that ruled in 1982.

Recently, the US has adapted a new method of measuring inflation using chained values instead of a base year, see consumer price index.

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