What's the Difference Between Nominal and Real?

What Does Nominal Mean?

An unadjusted rate, value or change in value. This type of measure often reflects the current situation, such as the
current price of a car, and doesn't make adjustments to reflect factors such as seasonality or inflation, which provide a
more accurate measure in real terms.
In most cases, value is measured in nominal terms rather than real terms, which make adjustments to give a more
accurate measure. For example, if you buy a $900 bond and are paid $1,000 for it a year later, your rate of return is
11.1%. This is the nominal rate of return; it is unadjusted and reflects the return on your bond. However, to get a more
accurate picture of the actual return, the rate needs to be adjusted for inflation because the purchasing power of your
money has likely changed over the one-year period. Therefore, if inflation for that year is 5%, the real rate of return is
only 6.1% (11.1%-5%).

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:

In economics, nominal value refers to a value expressed in money of the day (year, etc.), as opposed to real value, which
adjusts for the effect of inflation on the nominal value. Changes in nominal value of some commodity bundle over time
can happen because of a change in prices and/or changes in the quantities in the bundle, whereas changes in real values
reflect only changes in the quantities, Qs of the bundle, not changes in the prices, Ps. Real values are used to index
changes in nominal amounts (in different years, say) net of any price changes. They are often used for restating nominal
income to "real income" and for aggregate measures such as gross domestic product to express the nominal amount in
real terms.
A single real value has no meaning. Real values always express a quantity existing at some point in time relative to a
quantity existing at some other point in time — for example, the output of an industry this year relative to its output last
year. Frequently, a series of real values is given, with all members of the series expressing their quantity relative to one
chosen point, which is called the base period of the series. For example, gross domestic product figures for a succession
of years might all be expressed in terms of the prices in one base year.
The nominal value of a commodity bundle in a given year may be converted to a real value by replacing the then-current
prices in the bundle with prices that prevailed in the base year. Real values in different years then express values of the
bundles as if prices had been constant for all the years. Nominal values are related to prices and quantities (P and Q) and
to real values by the following definitional relation:

Nominal value/real value = P•Q/Q = P or alternatively nominal value/P= real value = Q.

Here P serves as a price index.1 It is usually constructed to equal 1.00 or 100 in the base year. In the latter case, the
relation becomes:
(Nominal value/real value)•100 = P.

1
A price index (plural: “price indices” or “price indexes”) is a normalized average (typically a weighted average) of prices for a
given class of goods or services in a given region, during a given interval of time. It is a statistic designed to help to compare how
these prices, taken as a whole, differ between time periods or geographical locations.
Price indices have several potential uses. For particularly broad indices, the index can be said to measure the economy's price level
or a cost of living. More narrow price indices can help producers with business plans and pricing. Sometimes, they can be useful in
helping to guide investment.
Some notable price indices include:
* Consumer price index: A consumer price index (CPI) measures changes through time in the price level of consumer goods and
services purchased by households. The CPI is a statistical estimate constructed using the prices of a sample of representative items
whose prices are collected periodically.
The annual percentage change in a CPI is used as a measure of inflation. A CPI can be used to index (i.e., adjust for the effect of
inflation) the real value of wages, salaries, pensions, for regulating prices and for deflating monetary magnitudes to show changes in
real values. In most countries, the CPI is, along with the population census and the USA National Income and Product Accounts, one
of the most closely watched national economic statistics.
* Producer price index: A Producer Price Index (PPI) measures average changes in prices received by domestic producers for their
output. Its importance is being undermined by the steady decline in manufactured goods as a share of spending.
* GDP deflator: GDP deflator (implicit price deflator for GDP) is a measure of the level of prices of all new, domestically
produced, final goods and services in an economy. GDP stands for gross domestic product, the total value of all final goods and
services produced within that economy during a specified period.

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The nominal/real value distinction can apply not only to time-series data, as above, but to cross-section data varying by
region or householder characteristics.

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.

What Happens if Interest Rates Go To Zero?

Zero Nominal Interest Rates
A zero nominal interest rate occurs when the interest rate is the same as the inflation rate. If inflation is 4% then interest
rates are 4%. If you lent or borrowed for a year at a zero real interest rate, you would be exactly back where you started
at the end of the year. I loan $100 to someone, I get back $104, but now what cost $100 before costs $104 now, so I'm
no better off.
Typically nominal interest rates are positive, so people have some incentive to lend money. During a recession, however,
central banks tend to lower nominal interest rates in order to spur investment in machinery, land, factories, etc. If they

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cut interest rates too quickly, they can start to approach the level of inflation. Inflation will often rise when interest rates
are cut, since these cuts have a stimulative effect on the economy.

Real Rate Of Return

What Does Real Rate Of Return Mean?
The annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other
external effects. This method expresses the nominal rate of return in real terms, which keeps the purchasing power of a
given level of capital constant over time.
Adjusting the nominal return to compensate for factors such as inflation allows investors to determine how much of their
nominal return is actually real return.
For example, let's say your bank pays you interest of 5% per year on the funds in your savings account. If the inflation
rate is currently 3% per year, then the real return on your savings today would be 2%. In other words, even though the
nominal rate of return on your savings is 5%, the real rate of return is only 2%, which means that the real value of your
savings only increases by 2% during a one-year period.

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