What it means
A dollar today does not buy what a dollar bought twenty years ago. If prices rise, the same amount of money commands fewer goods, so the nominal figure (the number as stated) can mislead.
Real value removes this distortion by restating everything in the money of a single reference year. To find the real value, you divide a nominal amount by a price index and multiply by the index's base.
A price index is a number that tracks the cost of a fixed basket of goods over time, with a chosen base year set to 100. If the index stands at 120, prices are 20% higher than in the base year, and a nominal amount is worth correspondingly less.
Businesses use real values in many places. They compare revenue across years, assess whether wage rises beat inflation, and judge whether an asset has genuinely appreciated.
Government statistics on growth also use real values, so that output is not overstated by rising prices. The choice of price index matters.
A general consumer price index suits household spending, while a construction cost index or a producer price index may suit a building firm. Using the wrong index can give a wrong picture, so state which one you used and which base year you chose.
Real value is different from market value, which is simply the price an asset would fetch today. An asset can rise in market value but fall in real value if the rise is smaller than inflation.
This is a frequent source of confusion in property and share discussions. In contracts, real value is also used to protect payments from inflation.
A lease or a supply agreement may include an indexation clause that raises the price each year in line with a price index, so the real value of the payment stays roughly constant. Without such a clause, the party receiving a fixed amount slowly loses out.
In practice
Real-world examples.
Example
A manufacturer reports sales growth of $4,000,000, from $40,000,000 to $44,000,000, or 10%. Prices across its industry rose 6% over the same period. In real terms, sales grew by only about 3.8%, which is 1.10 / 1.06 - 1.
Example
A homeowner bought a house for $300,000 and sold it for $360,000 fifteen years later. Prices in the economy rose by 50% over that time, so the purchase price in today's money was $450,000. The sale was a loss in real terms despite the apparent profit.
Example
A union negotiating a pay deal shows that the average wage rose 3% while prices rose 5%. The real value of wages fell by about 1.9%. The union uses this figure to argue for a larger increase. The employer replies that productivity gains should also be considered, and the two sides agree to review the numbers again in six months.
Formula
Calculation
Real value = Nominal value / Price index x 100
Suppose an employee's salary is $90,000 today, and the price index stands at 120 compared with a base year of 100. The real value is 90,000 / 120 x 100 = $75,000 in base year money. If she earned $78,000 in the base year, her real pay has fallen by 78,000 - 75,000 = $3,000, even though her nominal pay rose by $12,000.Case study
Seen in the real world.
Redwood Furniture Works is an illustrative, fictional company whose owner proudly points out that revenue has doubled over ten years, from $2,000,000 to $4,000,000. A new finance manager adjusts the figures using a price index that rose from 100 to 160 over the decade.
Restating the final year in the money of the first, the manager divides 4,000,000 by 1.60 to get $2,500,000. The real growth is therefore 25%, not 100%, because most of the increase came from higher prices rather than more furniture sold.
The owner is disappointed but grateful, because the analysis shows that unit sales were nearly flat. In this illustrative case, the company shifts its focus to winning new customers instead of relying on price rises. The manager also restates costs in the same way and finds that rent and wages grew faster than prices, which squeezed profit more than the owner had realised.
Watch out
Common mistakes.
- Comparing nominal figures from different years as if they were measured in the same money.
- Using a price index that does not match the spending being measured, or failing to state the base year.
- Treating real value as the same thing as market value or fair value.
Questions
People also ask.
What is the base year?
It is the reference year in which the price index is set to 100, and all real values are expressed in that year's money.
Is real value the same as inflation-adjusted value?
Yes, the two phrases mean the same thing in everyday use.
Can real value rise while nominal value falls?
Yes, in a period of falling prices, a nominal amount can drop while still buying more. This is rare in most economies, but it has happened during deflation.
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