The term “real” encompasses two primary definitions:
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Actual vs. Nominal: In general usage, “real” signifies something that is actual, existing, or authentic, as opposed to being nominal, theoretical, or artificial.
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Economic Measures: In economics, “real” often refers to measures such as price and income that have been adjusted for inflation over time to allow for the comparison of actual purchasing power.
The Importance of Real Values in Economics
Real vs. Nominal Values
To understand economic measurements, it is critical to distinguish between real and nominal values. Nominal values represent the face value of an amount of money without adjustments, while real values are adjusted for inflation, allowing for a true comparison over time.
Example: If the nominal income in 2000 was $50,000 and the nominal income in 2020 is $70,000, simply comparing these figures doesn’t take into account inflation. Real income would adjust the 2020 income to reflect the purchasing power relative to 2000.
Adjusting for Inflation
Inflation erodes purchasing power, and without adjusting for it, comparisons over time can be misleading. The formula to calculate real values (e.g., income or GDP) is:
Price Index: A measure (like CPI - Consumer Price Index) used to adjust nominal values to real values.
Types of Real Measures
- Real GDP: Gross Domestic Product adjusted for inflation, representing the true value of goods and services produced.
- Real Income: Income adjusted for inflation, reflecting actual purchasing power.
- Real Interest Rates: Nominal interest rates adjusted for inflation, showing the true cost of borrowing or returns on investment.
Applications and Examples
Real GDP
Example: Country A’s nominal GDP in 2022 is $1 trillion, with a price index of 120 (base year 2015). Real GDP is calculated as:
This adjustment provides a clearer picture of the country’s economic growth compared to previous years.
Real Income
Example: An individual’s nominal income increased from $50,000 in 2000 to $70,000 in 2020. Suppose the price index for 2020 relative to 2000 is 140:
This proves that the individual’s purchasing power remained constant despite the nominal income increase.
Historical Context
The differentiation between real and nominal values has become particularly important since the 1970s, a period marked by significant inflation. This spurred the adoption of real measures to better understand economic phenomena and devise appropriate policy responses.
Related Terms
- Nominal: Values unadjusted for inflation.
- Inflation: The rate at which the general level of prices for goods and services is rising.
- Purchasing Power Parity (PPP): A theory that measures prices at different locations using a common basket of goods.
- Consumer Price Index (CPI): An index measuring the average change in prices paid by urban consumers for a market basket of goods and services.
FAQs
Why is adjusting for inflation necessary?
How often are economic values adjusted for inflation?
What are the implications of ignoring real values?
References
- Samuelson, P. A., & Nordhaus, W. D. (2010). Economics. McGraw-Hill Education.
- Mankiw, N. G. (2014). Principles of Economics. Cengage Learning.
Summary
Distinguishing between real and nominal values is fundamental in economics. Real values provide a more accurate measure of economic phenomena by adjusting for inflation, ensuring meaningful comparisons over time, and informing sound economic policy and personal financial decisions.
