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Real vs Nominal Value

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 nominal value is the current value, without taking inflation or other market factors into account. It is the face value of the good.

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.

If we want to look at the real price of an apple we have to choose a base year and calculate how much the value of the apple has changed from the base year to the current year. This tells us how much the price of an apple has changed.

The real value, also known as the relative price, is the value after it has been adjusted for inflation. The real value takes the prices of other market items into account to calculate it.

Inflation is an overall increase in the price level across the entire economy.

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.

Nominal valueReal value
The face value of a good.An abstract value that is based on a past value.
The wage you are paid for labor. Useful as a tool of comparison between past and present values.
The prices we see in daily life. It is relative to the base year that the nominal value is being compared to.

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.

GDP

A nation's Gross Domestic Product (GDP) is the value of all final goods and services produced in that year in that nation.

It is calculated by adding together a nation's private consumption (C), investments (I), government spending (G), and net exports (X-M).

As a formula it can be expressed as:

There is so much more interesting stuff to learn about GDP!

Head over to our explanation - GDP to learn all about it.

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%.

Real vs. Nominal Value, Real GDP vs Nominal GDP graph, StudySmarterFig.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.

For example, if someone is selling a lawnmower, they need to know the nominal price or the current value of the lawnmower. The past price or the level of inflation does not matter to them, or the buyer, when engaging in this kind of private transaction because both are in the present economy and market for lawnmowers.

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).

The Consumer Price Index (CPI) is a statistical series that measures the changes in prices in a scientifically collected "basket" of goods as weighted averages. For the United States, it is calculated by the U.S. Bureau of Labor Statistics and released monthly.

How The United States Government Calculates The CPI

The CPI for the United States is calculated by the U.S. Bureau of Labor Statistics and released to the public on a monthly basis and is adjusted for errors annually.

It is calculated by selecting a basket of goods in the current year and the base year that is chosen.

Basket of GoodsPrice of Goods in Base YearPrice of Goods in Current Year
1 pound of apples$2.34$2.92
1 bushel of wheat$4.74$5.89
1 dozen eggs$2.26$4.01
Total Price of Basket$9.34$12.82
Table 2 - Calculating CPI with a basket of goodsThe formula for CPI is:This is a very simplified version of calculating the CPI. The BLS takes many more items into account for their basket of goods and optimizes the items in it to best reflect consumer spending habits.

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:

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

Both formulas are the same, the second one is simply already one step further having isolated the value that is being solved for.

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:

A tech firm pays its cyber security chief $87,000 per year as a starting salary in 2002. Now it is 2015 and the same employee gets paid $120,000. This means that their income has risen by 37.93%. The CPI for 2002 is 100 and the CPI for 2015 is 127. Calculate the real wage of the employee using 2002 as a base year.

YearSalary (Nominal Income)CPIReal Income
Year 1 (2002)$87,000100
Year 2 (2015)$120,000127
Table 3 - Comparing real vs. nominal wagesGiven the change in CPI, we can calculate the rate of inflation by using the formula for calculating percent change:

There was a 27% increase in inflation.

This means that of the 37.93% raise the employee received, 27% of it went towards combating inflation and they only received a 10.93% real wage increase.

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.

Nominal Value vs Real Value Example

To understand the difference between the nominal value and the real value it is best to calculate some examples. The side-by-side comparison between the two values will highlight the difference in current prices to what they would be if inflation did not cause prices to rise.

The national average price of gasoline in the United States for 2021 is $4.87. This is the nominal value. To find the real value we must choose a base year. In this case, we will choose the year 1972. The CPI in 1972 was 41.8. The CPI for 2021 is 271.0.1 The average price of gasoline in 1972 was $0.36 per gallon.2 Now let's find the real value of gasoline today using the following formula:

Now let's plug in our values for the price of gasoline and the CPIs.

The real value of gasoline today is $2.33. As we can see when comparing the real value to the nominal value of gasoline today, there is a significant difference. This difference is due to the rise of inflation over the last 49 years.

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.

In 2021 the average sales price of a gallon of milk in the United States was $3.66. In 1978 the average price of a gallon of milk was about $0.91. The CPI in 1978 was 65.2 and in 2021 it was 271.1 Using the formula, let's calculate how much a gallon of milk would cost today in 1978 prices. We will be using the formula for real value:

Now let's plug in our values for the base price of a gallon of milk and the CPIs.

In this example, we see that milk is $0.12 cheaper in today's money than it would be if the price of milk had kept up with inflation. This tells us that people in the United States were paying proportionally more for milk in 1978 than they are today.

Real vs Nominal Value - Key takeaways

  • The nominal value is the current value, without taking inflation or other market factors into account. It is the face value of the good.
  • The real value, also known as the relative price, is the value after it has been adjusted for inflation. The real value takes the prices of other market items into account to calculate it.
  • 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.
  • 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.
  • This comparison of the real versus the nominal value serves to help us relate the prices and GDP of the past to those present.

References

  1. Minneapolis Fed, Consumer Price Index, 1913-, 2022, https://www.minneapolisfed.org/about-us/monetary-policy/inflation-calculator/consumer-price-index-1913-
  2. Office of Energy Efficiency and Renewable Energy, Fact #915: March 7, 2016 Average Historical Annual Gasoline Pump Price, 1929-2015, 2016, https://www.energy.gov/eere/vehicles/fact-915-march-7-2016-average-historical-annual-gasoline-pump-price-1929-2015
  3. Bureau of Economic Analysis, Gross Domestic Product, https://www.bea.gov/resources/learning-center/what-to-know-gdp

Frequently Asked Questions about Real vs Nominal Value

The nominal value is the current value, without taking inflation or other market factors into account. The real value, also known as the relative price, is the value after it has been adjusted for inflation.

Real values allow for a more accurate comparison between the prices of goods and services than nominal values. Nominal values are more important in everyday life.

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. 

To calculate the real value from nominal values you divide the current CPI by the CPI of the base year. Then you multiply this by the price of the good from the base year to figure out the real value of the good. 

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. Another nominal value is the national average price of gasoline in the United States for 2021 was $4.87. 

Final Real vs Nominal Value Quiz

Question

What is real value?

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Answer

Real value is the value after it has been adjusted for inflation. The real value takes the prices of other market items into account to calculate it.

Show question

Question

What is nominal value?

Show answer

Answer

The nominal value is the current value, without taking inflation or other market factors into account. It is the face value of the good.

Show question

Question

What is inflation?

Show answer

Answer

Inflation is an overall increase in price across the entire economy.

Show question

Question

What does CPI stand for and what is it?

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Answer

It stands for Consumer Price Index and is a statistical series that measures the changes in prices in a scientifically collected "basket" of goods as weighted averages.

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Question

What are the 3 inputs necessary for calculating real value?

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Answer

1. The current CPI of the selected basket of goods.

2. The CPI of the base year.

3. The price of the selected good in the base year.

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Question

What is meant by a basket of goods?

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Answer

The basket of goods is a scientifically selected collection of goods made up of items that are frequently used by consumers.

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Question

What is the importance of nominal values?


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Answer

Nominal values are important for determining the current value of a good or service. 

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Question

Why are real values important in economics?

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Answer

The real values of goods are important when evaluating the health and productivity of the economy. They allow for a more accurate comparison of the prices of goods and services between the past and current values.

Show question

Question

What is the difference between the real value and the nominal value?

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Answer

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 of inflation.

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Question

What is the most common use of real and nominal values?

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Answer

The most common use of real and nominal values is when we are looking at a nation's gross domestic product (GDP).

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Question

Find the real value of an apple in 2020 when the nominal value is $3.10 per pound. The value of an apple in 2003 was $1.36 per pound. The CPI in 2003 was 137. The current CPI is 203.

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Answer

Real value = $1.36 x (203/137)

Real value = $1.36 x 1.48

Real value = $2.02 per pound

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Question

Find the real value of a bale of hay in 2021 when the nominal value is $27 per bale. The value of a bale in 1998 was $5.50 per bale. The CPI in 1998 was 97. The current CPI is 237.

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Answer

Real value = $5.50 x (237/97)

Real value = $5.50 x 2.44

Real value = $13.44

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Question

Calculate real income when the nominal income is $27,425 and the CPI is 152.

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Answer

Real Income = ($27,425/152) x 100

Real Income = 180.43 x 100

Real Income = $18,043

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