Real vs. Nominal

In economics, people always have expectations for prices and value of goods. Often these expectations provide a benchmark for comparison of prices and determining the state of a given market. The economic value of a commodity, therefore, when expressed in terms of fixed currency value, is what we refer to as nominal value. The nominal value is sort of static, and may not incorporate, or even put into consideration some important aspects of economics and general price changes in the market. Usually the nominal value is considered an estimation rather that a representation of the real value of an economic quantity. In order to get a more accurate value of the market, the nominal value is used against other price determinants. The most prominent such determinant is usually inflation. Since the effects of inflation are not considered in a nominal analysis, it is important that in a real value economics, it should be put into consideration. Therefore, to determine the real value of a commodity or a market, the rate of inflation is subtracted from the nominal value of the economic factor being measured. The real value is much more accurate than the normal value, although that is not to say that the nominal value is any less important at all. Indeed, it would be difficult to do any credible economic analysis without first having tentative values.

The use of real and nominal values is prominent in economics, and it is inevitable that anyone involved in economics at any given level will have to come across these terms at one point or another. One good example of how real and nominal values co-relate is in calculating interest rates. Interest rates are a common feature in economics, but there is a difference between real rates and nominal rates. More likely than not ,when people talk about interest rates, they are referring to nominal interest rates, rather than real interest rates- unless of course they sate that they are talking about the later.

Here is a typical case scenario: When I buy stocks for $200 at the start of the year, and I sell them at the end of the year and earn $210, we say that I have earned an interest of 5%. This is my nominal interest rate. However, inflation needs to be factored in order to get the real value of my interest rate. Since, for example, in that year the inflation rate was 3%, it means that if I was to buy goods for $200 at the start of the year, I would have to buy the same goods for $206 at the end of that year. The effect of inflation means that the real value of my interest is much less, because of reduced purchasing power as a result of inflation. Therefore to get the real value of what I have earned, I would have to subtract the inflation rate from the nominal interest rate. In this case therefore, the real interest rate is 2%, which reflects the real value of my stocks.

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