What it means
Money loses buying power when prices rise, so a dollar today buys less than a dollar did years ago. Quoting a figure in real terms strips out that effect and asks how much the money can actually buy.
It is the honest way to compare a number from one year with a number from another. To convert, analysts pick a base year and divide each later amount by a price index (a measure of how prices have moved).
The result expresses every year in the money of the base year, so you compare like with like. Governments and statistical agencies publish these indices regularly.
This matters in business whenever figures span several years. A company that reports 10% sales growth while its prices rose 8% has grown only about 2% in real terms, and the underlying volume of what it sold barely changed.
Real terms are used for revenue, wages, budgets, interest rates and investment returns. For interest, the real rate is the nominal rate adjusted for inflation, and it can be negative when inflation is higher than the rate on offer.
The choice of price index affects the answer. A consumer price index suits wages and household spending, while a business may prefer an index for its own inputs or its own selling prices.
Real terms should not be confused with constant currency, which removes the effect of exchange rates instead of inflation. A multinational may report growth on both bases, and the two adjustments can pull in different directions.
Always check which adjustment a report is describing.
In practice
Real-world examples
Example 1
A retailer's revenue rose 8% in a year when its selling prices rose 5%. Real growth is 1.08 / 1.05 - 1 = about 2.9%. The board concludes that volume grew modestly and most of the headline gain came from higher prices.
Example 2
A retiree receives a fixed pension of $2,000 a month. After years in which prices doubled, it buys what $1,000 bought at the start. The pension has fallen by half in real terms even though the payment never changed.
Example 3
A bond pays a nominal yield of 6% when inflation runs at 4%. The real yield is 1.06 / 1.04 - 1 = about 1.9%. An investor comparing the bond with a savings account that pays 3% sees that the real gap is smaller than it first appears.
Think of it
Imagine running on a moving walkway at the airport. Your nominal speed is how fast you walk, but your real speed is how much ground you actually gain compared to someone standing still while the belt moves against you.
Formula
Calculation
Real value = Nominal value / (1 + Cumulative inflation)
Real growth rate = (1 + Nominal growth rate) / (1 + Inflation rate) - 1
Suppose an employee's pay rises from $60,000 to $75,000 while prices rise by a total of 25%. Nominal pay rose by 75,000 / 60,000 = 1.25, or 25%. In real terms, pay is 75,000 / 1.25 = $60,000 in the money of the earlier year. Real growth is 1.25 / 1.25 - 1 = 0%, so the employee has the same buying power as before.Case study
Seen in the real world
Larkfield Foods is an illustrative, fictional packaged-foods maker. Its revenue rose from $20,000,000 to $23,000,000 over three years, and the sales director presented this as 15% growth.
The finance team noted that food prices in its sector had risen 12% over the same period. Real revenue was 23,000,000 / 1.12 = about $20,535,714, which is real growth of about 2.7% across three years.
The board realised that most of the increase was price rises rather than extra volume, and it set targets for unit sales alongside revenue. In this illustrative story, the change in focus led to better decisions about promotions and capacity. The finance team also began to show wages and costs in real terms in its annual report. That made it easier for managers to see whether pay rises were keeping up with prices, and whether cost savings were genuine or simply a result of inflation running below the plan.
Watch out
Common mistakes
- Comparing figures from different years without adjusting for inflation, which makes growth look larger than it was.
- Subtracting inflation from the growth rate and treating the result as exact, when dividing the growth factors is the correct method for larger rates.
- Using a general consumer price index to adjust figures where an industry-specific index would be more accurate.
Questions
People also ask
What is the difference between real and nominal terms?
Nominal figures are the raw amounts at the prices of the time, while real figures are adjusted for inflation so they can be compared across years.
Can a real growth rate be negative while the nominal rate is positive?
Yes, if inflation is higher than the nominal growth, then buying power falls even though the figure goes up.
Which year should be used as the base year?
Any year can be used, but the most recent year is common because the results are then stated in today's money. Whatever year is chosen, it should be stated clearly in the report.