What's
Real?
Are
you dealing with Nominal or Real Wages ...
What's the Difference Between Nominal and Real?
As litigation support specialists, we are often asked "What's
the difference between nominal and real?" Terms like
“real inflation rate”, “real interest rate”,
“nominal inflation rate”, ”nominal interest
rate” “nominal wages” and “real wages”
are frequently mentioned in media reports on the economy,
as well as in business valuation and economic loss and damage
calculation reports.
The use of the word “nominal” implies that the
effects of inflation have not been considered in the quoted
rate. Where the use of the word “real” means that
the effects of inflation have been considered. Let’s
look at several examples:
Nominal Interest
Rates vs. Real Interest Rates
An investor buys a oneyear treasury bond with a face value
of $1,000 and has an interest rate of 6%. For the sake of
this example, lets assume that the interest is paid at the
end of one year, when the bond matures. An investor paid $1,000
for the bond, and one year later receives $1,060. $1,000 is
a return of principal and $60 represents the interest earned
on the investment. An annual return of $60 on a $1,000 investment
equates to an interest rate of 6%. This is the nominal interest
rate. The rate of inflation does not impact the calculated
interest rate. When people speak of interest rates, it is
usually in this context and refers to the nominal interest
rate, unless specified otherwise.
Lets assume that the inflation rate was 2.5% during the oneyear
period that the bond was held. This simply means that the
same market basket of goods and services which would cost
$1,000 at the time the bond was purchased would cost $1,025.00
the day the bond matured. The purchasing power of the initial
investment declined, i.e. a $1,000 in year one has less purchasing
power the following year. The investor who purchased the bond
with a 6% nominal interest rate for $1,000 and in one year
receives $1,060. The investor can then buy the market basket
of goods for $1,025, leaving a balance of $35. Thus the $1,000
bond will earn the investor $35 in real income ($60 interest
minus the increase in the cost of the market basket of goods
and services); a real interest rate of 3.5%. Economists refer
to this calculation as the Fisher Equation: Real Interest
Rate = Nominal Interest Rate  Inflation.
Nominal
or Real
Gross Domestic Product
(GDP) Growth
GDP is the value of all the goods and services produced in
a country. Nominal GDP measures the value of all the goods
and services produced expressed in current prices. 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 2001, the economy of a country produced
$100 billion worth of goods and services based on actual prices.
Since we're using 2001 as a basis year, the nominal and real
GDP are the same. In the year 2002, the economy produced $110
billion worth of goods and services based on year 2002 prices,
based up 2001 prices those same goods and services have a
value of $103 billion.
Nominal vs. Real Wages
Wages work in the same way as the nominal interest rate. Assume
your nominal wage is $100,000 in 2002 and $110,000 in 2003,
but the price level has risen by 8%. The $110,000 salary in
2003 buys what $101,852 would have in 2002, so your real wage
has increase by only $1,852. The mathematical formula for
determining real wages is:
Real Wage = Nominal Wage / 1 + % Increase in Prices Since
Base Year ($110,000/1.08=$101,852)
Year
2001 

Nominal
GDP = $100B 
Nominal
GDP = $110B 
Real
GDP = $100B 
Real
GDP = $103B 

Nominal
GDP Growth Rate = 10% 

Real
GDP Growth Rate = 3% 
