“Nominal” and “real” are key economic terms to describe value. You’ll encounter them when you apply for a loan, use a credit card, are paid your salary or read up on GDP growth. Here we tell you what they mean and why it’s important to understand how they affect you.
Imagine you’ve kept 5 euros in your wallet for 10 years. In the first year, you could buy a newspaper, coffee or bus ticket and still have money left over. Now, think about how far those 5 euros would go these days. Probably not as far as before. But why? It’s simple. Your money's nominal value is still 5 euros; but its real value (i.e. what you can buy with it) changes because of inflation and other things that cause prices to rise.
Unlike the real value, the nominal value of something does not factor in market conditions. In economics, the nominal value of something is its current price; the real value of something, however, is its relative price over time.
Both can be used to talk about the value of not only money, but also your wages, share prices and other things that have financial value. If you earn 2,000 euros every month, 2,000 euros is the nominal value of your pay. But if inflation for the year is 4%, your pay enables you to buy fewer things since 2,000 euros minus 4% is 1,920 euros. Therefore, your real purchasing power relative to the base year has fallen.
Nominal and real values also apply to:
- InterestInterest can be the cost of the money you borrow from a bank and the yield of your savings deposit or investments. If you invest in a fund, the agreed rate of return is your investment's nominal rate of interest. Its real rate of interest, however, includes things like fees, expenses, taxes, and inflation. If you invested 100 euros at a nominal interest rate of 3% per year, you’ll have 103 euros by the end of the year. But if inflation is 2%, your investment's real rate of interest is only 1% (nominal interest minus inflation).
- GDPGross domestic product (GDP) is one of the most widely used indicators of economic development. It gives us a monetary value of the wealth (good and services) a country or region creates in a given period. The nominal GDP is based on market (or current) prices of goods and services. However, when prices increase due to inflation, nominal GDP might grow, even if output hasn’t.
Because real GDP factors in prices adjusted for inflation, it tells the relative value of output over time. To calculate real GDP, we take the prices in a given base year and the “GDP price deflator” formula to express nominal output value in real terms (the price difference between the current year and the base year). Real GDP tells us if production capacity has grown or declined, regardless of the market price of goods and services.
Nominal and real values can reveal different things about the economy. The next time you see nominal and real values on a bank statement, in a returns report and in financial news, you’ll know what they mean in order to make better financial decisions.
