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What's Real?

September 1, 2013

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 one-year treasury bond with a face value of $1,000 and has an interest rate of 6%. For the sake of this example, let's 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.

Let's assume that the inflation rate was 2.5% during the one-year 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); or 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 the 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 increased 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)

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