Question

Explain the real vs. nominal distinction in economic measurement. Give examples and discuss why it is important.

Answer 1

Nominal value is measured in terms of money. Whereas real value is the value which has been adjusted for inflation, enabling comparison of quantities as if the prices of goods had not changed on average.

In other words, nominal value doesn't take into account the inflation factor while a real value is adjusted to remove the effects of inflation and thus gives a value in real terms.

Examples:

Nominal and Real Interest rate: Suppose a bank loans a person $200,000 to purchase at a rate of 3%—the nominal interest rate not factoring in inflation. Assume the inflation rate is 2%. The real interest rate the borrower is paying is 1%. The real interest rate the bank is receiving is 1%.

Nominal and Real wages: If you receive an 8% increase in your wages from $100 to $108, this is the nominal increase. However, if inflation is 2%, then the real increase in wages is (8-2%) 6%.  

The distinction between nominal and real measurement is important as the real measurement gives us the real purchasing power that a person has by removing the influence of inflation. The real wage is a better guide to how your living standards changes. It shows what you are actually able to buy with the extra increase in wages. For example, if wages increased by 80%, but inflation was also 80%, the real increase in wages would be 0% – in effect, despite the monetary increase in wages of 80%, the amount of goods and services you could buy would be the same. Similarly, 3% interest interest rate would give the lender nothing if the inflation turns out to be exactly 3% . Hence, it is important to take inflation into account while determining the interest rate or wages of income so that we can estimate its real value in terms of the basket of goods and services that can be purchased with the given income.