Nominal Prices and Real Prices

Nominal prices are current or unadjusted prices for inflation, while real prices are prices adjusted to account for inflation.

Nominal Prices

Nominal prices are absolute prices not adjusted for inflation, sometimes also called current or actual prices. These are the prices directly observed in the market at a given time. These prices reflect the monetary value of goods and services as they are paid for using a reference currency, without considering changes in the purchasing power of the currency.

Real Prices

Real prices are prices in relation to an aggregate price measure, i.e., prices adjusted to account for the effect of inflation, usually using some price index like the CPI. Real prices are also called constant prices. As inflation-adjusted prices, they allow for more accurate price comparisons across different periods of time, as inflation-adjusted prices help evaluate how much the actual cost of a good or service has changed in terms of purchasing power.

Converting Nominal Prices to Real Prices

The formula to calculate the real price from the nominal price and the price index is as follows:

\[ P_{real} = \left( \frac{I}{P_n} \right) \times 100 \]

Where:

  • Preal: is the real price, adjusted for inflation.
  • I: is the price index (it can be the consumer price index, CPI, or any other relevant index that reflects changes in the price level).
  • Pn: is the nominal price, which represents the value of the good or service in monetary terms without adjusting for inflation.

This formula is used to convert a nominal price to its equivalent in real terms, removing the effect of inflation and allowing for better comparison of purchasing power.

The relationship between the price index and the nominal price is fundamental to understanding how changes in the price level affect the real value of goods and services. Below, we break down each component of the formula:

Components of the Formula

  • Price Index (I): This index measures the general price level of a basket of goods and services in a specific period. It is used as an indicator of the cost of living and inflation. A higher index indicates an increase in prices, implying that more money is required to purchase the same basket of goods.
  • Nominal Price (Pn): This is the price of a good or service in monetary terms at a given moment, without taking inflation into account. For example, if a product costs $200 today, that is its nominal price.
  • Real Price (Preal): This is the price of the good or service adjusted for inflation, which allows for meaningful comparison over time. It reflects the actual purchasing power of an amount of money in terms of prices in a base period.

By multiplying the ratio of the price index by 100, the relationship is transformed into a more easily interpretable format. This helps visualize the percentage change in purchasing power compared to the nominal price.

To convert nominal prices into real prices, we must use the price index that best suits what we want to measure. If it is a common product purchased by the average person, the consumer price index is appropriate. If it is a product typically purchased by companies or businesses, the producer price index is more suitable.

Example: Conversion of Nominal Prices to Real Prices

Below is an example that illustrates how to use the formula to calculate the real price from a nominal price, analyzing the case of a hamburger's price.

Suppose that in the year 2000, the nominal price of a hamburger was $5. By 2020, the nominal price of the same hamburger had increased to $10. Additionally, the price index in 2020 is 60.

We want to calculate the real price of the hamburger in 2020 using the following formula:

\[ P_{real} = \left( \frac{60}{10} \right) \times 100 \]

Where:

  • Preal: is the real price adjusted for inflation.
  • I: is the price index.
  • Pn: is the nominal price.

In this case, we substitute the values into the formula:

\[ P_{real} = \left( \frac{60}{10} \right) \times 100 \]

Solving the equation, we get:

\[ P_{real} = 6 \times 100 = 6 \]

Therefore, the real price of the hamburger in 2020 is $6.

Now, let's analyze the increase in the hamburger's price:

  • The nominal price increased from $5 in 2000 to $10 in 2020. This represents a nominal increase of $5.
  • The real price, considering the effect of inflation, is $6. This means that, in inflation-adjusted terms, the price of the hamburger has only increased $1 compared to the year 2000.

In summary, of the $5 increase in the nominal price:

  • $4 of the increase is due to inflation, meaning that increase reflects a nominal rise and does not represent a real increase in the hamburger's value.
  • $1 of the increase is the actual increase in the consumer's purchasing power, which is the increase that truly translates into a change in the product's value.

Additionally, a price index of 60 means that prices in the year 2020 are, on average, 60% of the prices in the base year. This indicates that, although the nominal prices of products may have risen, the inflation adjustment shows that, in real terms, prices have risen less than it seems.

This example shows how the nominal price can be misleading if not adjusted for inflation, as the real increase in the price of the hamburger is much smaller than what the nominal increase suggests.

In conclusion, we often want to compare today's price with past prices or the price that is likely to exist in the future. To make this comparison valid, we need to measure prices relative to the general price level. We must be careful to adjust prices for inflation when comparing over time, which means measuring prices in real terms rather than nominal terms.

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