EFA (23): Nominal and real

Today, in the 23rd item in our Economics for Amateurs (EFA) series, which you can find here each Monday, we are going to get real.

Look at the following statements and decide whether they are true:

• It is better to have a 10 per cent pay increase than a one per cent pay increase.
• If you are borrowing money, it is better to pay one per cent interest than three per cent.
• If you are lending money, it is better to receive five per cent interest than one per cent.
• It is better for a country if its gross domestic product (GDP) rises by three per cent than by one per cent.

For those of you who don't like numbers, I can imagine that was getting a bit tedious by the third example. So, for a bit of variation, here's a different type of statement:

• If the value of the pound falls against the dollar, British exports are more competitive in the US.
  

So, how many of the statements are true? Well, all of them actually, but only if we make a huge assumption: all other things being equal, or ceteris paribus, as economists prefer to say.

Specifically, we have to assume that, in each of the five statements, the price level is the same in the two alternatives. This brings us to a crucial distinction in economics, between nominal and real values.

For example, if you get a ten per cent pay increase, the nominal (actual) value of your salary has gone up by ten per cent. But if, at the same time, prices have risen by 20 per cent, the real value of your salary has gone down (by about ten per cent). The real value is the quantity of goods and services you can buy.

So, you would be better off with a one per cent increase if, at the same, inflation is zero, which is more or less the case in the eurozone. You would not only have a one per cent nominal increase in your salary, but also a one per cent real increase, also called a one per cent rise "in real terms".

The same principle applies to interest rates. We need to distinguish between the nominal rate of interest — the one the bank offers or charges you — and the real rate of interest, that is, the rate after deducting inflation.

Likewise with gross domestic product (GDP). What is important for living standards is not the growth of nominal (actual) GDP — which could simply be caused by rising prices — but the real growth in the amount produced. So real GDP is nominal GDP adjusted for inflation.

Similarly, if the pound falls against the dollar, ceteris paribus, British exports are more competitive compared to US goods. But this will not be the case if inflation in Britain is a lot higher than inflation in the US, increasing the prices of British exports as measured in pounds.

So again, we need to distinguish between the nominal exchange rate — the one quoted in the papers and at the banks — and the real exchange rate, which is the rate after adjusting for the inflation rates in different countries.

Exactly how real wages, real interest rates, real GDP and real exchange rates are calculated can be extremely complicated and a delight only for statisticians.

But the principle of the difference between nominal and real values is very important. So the next time you see a figure quoted in the media, you should ask yourself: has this been adjusted for inflation or not?