Real vs Nominal in Economics

A brief overview of Nominal and Real

1. Going from Nominal to Real P

2. It is useful to compare economic data over time. But, prices frequently change over time, and these price changes can distort our data. Remember, that what we are measure whether output grew, in the case of GDP, and a large price increase can fool us into thinking that output grew when all that happened was prices substantially increased. In order to be able to make comparisons over time we need to know who to adjust our date to remove the effect of price changes.

3. Nominal nominal figures are those that use current prices. No adjustment has been made. Real real figures are those in which an adjustment has been made. Real figures are calculated using constant prices.

4. The main steps involved in turning nominal figures into real figures are: Build a basket of goods and services Gather quantities produced and prices of the goods and services of the basket used in the basket Calculate the nominal figure which is simply P x Q Choose a base year to compare all other years to Replace all prices with the prices of the base year Recalculate P x Q to get the real figure

5. Step 1: Build a Basket of Goods and Services We are going to simplify things and assume that there are only two goods in the economy: pizza and soda.

6. Step 2: Find Information on quantities and prices 2005 2006 Item Q P Q P Pizza 100 $10 150 $20 Soda 50 $2 75 $4

7. Step 3: Calculate the Nominal Figure 2005 2006 Item Q P Total Q P Total Pizza 100 $10 $1000 150 $20 $3000 Soda 50 $2 $100 75 $4 $300 $1100 $3300 Nominal output is valued at $3300 in 2006 and $1100 in 2005. An increase of 3 times. But did we really produce three times as much output in 2006 than we did in 2005?

8. Step 4: Choose a Base Year We can choose any year we want for the base year so let’s choose 2005

9. Step 5: Replace all prices with base year prices 2005 2006 Item Q P Q P Pizza 100 $10 150 $10 Soda 50 $2 75 $2 Base Year

10. Step : Calculate Real GDP 2005 2006 Item Q P Total Q P Total Pizza 100 $10 $1000 150 $10 $1500 Soda 50 $2 $100 75 $2 $150 $1100 $1650 2005 Real GDP = $1100 (doesn’t change since we didn’t do anything to it 2006 Real GDP = $1650 --- it did increase but not by as much as nominal figure