Real vs. nominal in economics
In economics, a real value of a good or other entity has been adjusted for inflation, enabling comparison of quantities as if prices had not changed. Changes in real terms therefore exclude the effect of inflation. In contrast with a real value, a nominal value has not been adjusted for inflation, and so changes in nominal value reflect at least in part the effect of inflation.
A representative collection of goods, or commodity bundle, is used for comparison purposes, to measure inflation. The nominal (unadjusted) value of the commodity bundle in a given year depends on prices current at the time, whereas the real value of the commodity bundle, if it is truly representative, remains the same. The real value of individual goods or commodities may rise or fall against each other, in relative terms, but a representative commodity bundle as a whole retains its real value as a constant over time.
A price index is calculated relative to a base year. Indices are typically normalized at 100 in the base year. Starting from a base (or reference) year, a price index Pt represents the price of the commodity bundle over time t. In base year zero, P0 is set to 100. If for example the base year is 1992, real values are expressed in constant 1992 dollars, based at 100 for 1992. Also imagine for example, that the price of the commodity bundle has increased in the first year by 1%, then Pt rises from P0 = 100 to P1 = 101.
The inflation rate between year t - 1 and year t is:
The price index is applied to adjust the nominal value Q of a quantity, such as wages or total production, to obtain its real value. The real value is the value expressed in terms of purchasing power in the base year.
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