Video:The Difference Between Nominal and Real Variables
with Mike MoffattUnlike real variables, nominal variables don't account for inflation. Learn more about the difference between nominal and real, and how to factor them into different scenarios.See Transcript
Transcript:The Difference Between Nominal and Real Variables
What Are Nominal and Real Variables?
All of us have heard the terms nominal and real to describe things like interest rates. 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.
Nominal Interest 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. So the bond pays an interest rate of 6%, which is the nominal interest rate, and not accounted for inflation. In general, interest rate means nominal interest rate.Now suppose the inflation rate is 3% for that year. We can buy a basket of goods today for $100, or we can buy it next year for $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 - InflationSo in general, the real interest rate is lower than the nominal interest rate.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.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 = $100BYear 2001 Nominal GDP = $110B, Real GDP = $105BNominal GDP Growth Rate = 10%Real GDP Growth Rate = 5%Nominal Wages vs. Real Wages
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 down.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 YearOther 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. These are all statistics which account for inflation by using a base year for prices. Thanks for watching. To learn more, visit About.comAbout videos are made available on an "as is" basis, subject to the User Agreement.