Nominal Versus Real Quantities

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When you read about economics, you are likely to hear terms such as "gross domestic product (GDP)," "interest rate," and "exchange rate" used pretty frequently. Despite each of these appearing as a single, well-defined entity, however, economists actually have two important variations on terms like these that they use behind the scenes. Even though it's not made obvious in the news, the distinction between "nominal" quantities and "real" quantities is actually quite important.

Nominal quantities are those quantities that are defined in terms of currency or prices. Nominal GDP, for example, is the current dollar value of all final goods produced in an economy. Similarly, a nominal interest rate states the percentage of your dollar investment that you receive in interest, and a nominal exchange rate defines the price of one country's currency in terms of another country's currency. In other words, nominal quantities are what you probably think of when you hear these terms.

Real quantities, on the other hand, attempt to describe the world in terms of units of stuff (i.e. goods and services) rather than units of currency. In this way, a real interest rate represents what percent more stuff you can buy in the future rather than today if you save your money, and a real exchange rate represents how many units of foreign stuff you can get for an equivalent unit of domestic stuff (or vice versa, depending on how the exchange rate is defined).

Real GDP is a bit more complicated since it's really hard to describe aggregate output in an economy without referring to prices. (What, other than price, would tell you that a Boeing 747 should count more in GDP than an ice cream cone?) Therefore, real GDP does use a measure of prices, but it uses a fixed set of prices that is constant from year to year.

Put more simply, real quantities are quantities that have been normalized to account for monetary factors such as price levels and inflation. The appeal of real quantities is that, as the name suggests, they represent actual goods and services and are determined by "real" factors in the economy rather than being driven by nominal changes in money and prices. Real GDP, at least in the long run, is determined by the amount of labor, capital, and technology in an economy. Real interest rates are determined by the supply of and demand for loanable funds. (The precise determinants of real exchange rates are somewhat less clear.) In other words, economists believe that changes in nominal factors such as the money supply only have a lasting impact on nominal rather than real quantities in an economy.