Nominal and real variables

As is explained above, in the case of inflation, a given amount of money can buy increasingly fewer goods. This is the same as saying that there is a fall in the value of money or a decrease in its purchasing power. This observation brings us on to another important economic issue: the difference between nominal and real variables. A nominal variable is one that is measured in current prices. Such variables usually move with the price level and therefore with inflation. In other words, the effects of inflation have not been accounted for. Real variables, however, such as real income or real wages, are variables where the effects of inflation have been deducted or “taken out”.

Let us assume that a worker’s earnings increase by 3 % in nominal (i.e. in money) terms per year, in other words, his monthly earnings increase from, say, EUR 2000 to EUR 2060. If we further assume that the general price level were to increase by 1.5 % over the same period, which is equivalent to saying that the rate of inflation is 1.5 % per annum, then the increase in the real wage is ((103/101.5) – 1) x 100 ≈ 1.48 % (or approximately 3 % – 1.5 % = 1.5 %). Therefore, the higher the rate of inflation for a given nominal wage increased the fewer goods the worker can buy.

Another important distinction is between nominal and real interest rates (see also Box 3.2 below). By way of an example, let us suppose that you can buy a bond with a maturity of one year at face value which pays 4 % at the end of the year. If you were to pay EUR 100 at the beginning of the year, you would get EUR 104 at the end of the year. The bond therefore pays a nominal interest rate of 4 %. Note that the interest rate refers to the nominal interest rate, unless otherwise stated.

Now let us suppose that the inflation rate is again 1.5 % for that year. This is equivalent to saying that today the basket of goods will cost EUR 100, and next year it will cost EUR 101.50. If you buy a bond with a 4 % nominal interest rate for EUR 100, sell it after a year and get EUR 104, then buy a basket of goods for EUR 101.50, you will have EUR 2.50 left over. So, after factoring in inflation, your EUR 100 bond will earn you about EUR 2.50 in “real” income, which is equivalent to saying that the real interest rate is about 2.5 %. It is obvious that if inflation is positive then the real interest rate is lower than the nominal interest rate.