Real vs Nominal Value

When you listen to the news or read an article to catch up on the state of the economy, you will often hear, "real GDP has risen or fallen" or you will read "the nominal interest rate is..." But what on earth does that mean? What is the difference between a nominal value and a real value? Is one more correct than the other? And how do we calculate them? If you want to know the answer to these questions and get to the bottom of real versus nominal values, have a seat, and let's get into it!

Real vs Nominal Value Definition

The definition of real vs nominal values is that they are a way for us to compare the current value of a number or thing to its past value. The nominal value of something is its value measured in the current standard. If we take a look at the price of an apple today, we give it the nominal value of what it is worth in today's money.

The real value is the nominal value after it has been adjusted for inflation. Inflation is an overall increase in price across the entire economy. Since prices fluctuate with the supply of money and goods over time, there has to be a steady value that we can use as a control measure to compare the values accurately.

It is important to specify which value is used because inflation and changes in the money supply can have major impacts on how the price of goods and services is perceived. The most common use of real and nominal values is when we are looking at a nation's gross domestic product (GDP).

Difference between Real Value and Nominal Value

The difference between the real value and the nominal value is that the nominal value is the current price of a good in today's economy whereas the real value takes into consideration the effect that inflation and other market factors have on prices.

Let's have a look at some of the main differences and characteristics of these two values.

Table 1. Nominal vs real value, StudySmarter Originals

It is necessary to calculate and compare these values because it helps provide a better understanding of how the value of money is changing. It is important to be able to differentiate whether an increase in GDP is due to inflation or actual economic growth.

If GDP is rising at the same rate as inflation, then there is no economic growth. If the increase in GDP exceeds the rate of inflation then this is an indicator that there is economic growth. Choosing a base year as the standard for comparing annual GDP makes this comparison easier.

Another important area for understanding nominal vs real value is wages. The nominal wage is what is reflected on paychecks and in our bank accounts. As prices increase due to inflation, our wages need to reflect that, otherwise, we are effectively taking a pay cut. If an employer gives a 5% raise one year but the inflation rate of that year is 3.5%, then the raise is effectively only 1.5%.

Fig.1 - Nominal vs. Real GDP of the United States. Source: Bureau of Economic Analysis³

Figure 1 shows the comparison of the United States level of nominal GDP compared to its real GDP when using 2012 as a base year. Both lines follow a similar trend and meet and cross in 2012 because this is the base year for this particular graph. Using this base year as a point of comparison it shows that prior to 2012 the real GDP was higher than the nominal GDP of the time. After 2012 the lines switch because inflation today has made the nominal value of today's money higher than the real value.

Importance of Real Values and Nominal Values

In economics, real values are often seen as more important than nominal values. This is because they allow for a more accurate comparison of the prices of goods and services between past and current values. Nominal values have their place in the economy as they relate to the current price of a good.

Since the economy is ever-changing, the real values of goods are important when evaluating the health and productivity of the economy. Real values will indicate whether GDP is actually growing or just keeping up with inflation. If it is just keeping up with inflation then that tells economists that the economy is not growing or developing as expected.

Calculation of Real Value from Nominal Value

The calculation of the real value from the nominal value is done using the consumer price index (CPI). The CPI is a statistical series that measures the changes in prices in a scientifically collected "basket" of goods as weighted averages. The basket of goods is made up of items that are frequently used by consumers. The CPI is calculated for the United States by the U.S. Bureau of Labor Statistics (BLS).

Formula for Calculating Real Value

To calculate the real value of a good, we need:

• The current CPI of the selected basket of goods (CPI Year 2).
• The CPI of the chosen base year (CPI Year 1).
• The price of the selected good in the base year (Year 1).

With those 3 values, the real value of a good can be calculated using this formula:

$$\begin{gathered} \frac{PriceinYear2}{PriceinYear1}=\frac{CPIYear2}{CPIYear1} \\ or \\ PriceinYear2=PriceinYear1\times \frac{CPIYear2}{CPIYear1} \end{gathered}$$

The Price in Year 2 is the real value of the good.

Formula for Calculating Real vs. Nominal Income

Another important comparison to make is that of nominal income compared to real income. Sometimes we think that a raise will mean more money in our pockets when in reality inflation has raised prices even more than our bosses have raised our wages. Real income can be calculated with the same formula as the real values of goods, but to calculate income here, we will use this formula:

$\frac{NominalIncome}{CPI}\times 100=RealIncome$

It is important to differentiate between real and nominal income. It shows how rising wages do not necessarily mean that employees are making more money if an increase in income is negated by an increase in price.

This comparison of the real versus the nominal value serves to help us relate the prices and GDP of the past to those present. It also provides us with a numerical example of the effects of inflation on our economy.

Let's calculate another example. We will use the base year of 1978 and calculate the price of the average gallon of whole milk in the United States in 2021.