The meaning of nominal
The meaning of nominal can differ from one person to another. It may mean something with a minimal amount, or it can also mean fees, charges, or payments. Sometimes it can also be a price lower than a product or a service’s worth so that consumers can afford it. It is not that significant in an individual’s finances. Some people can say that it is an unadjusted rate price that does not give room for inflation. This article will tackle more information about the term nominal for our further understanding.
Understanding nominal further with an example scenario
Let’s discuss nominal on the economic side. When we say nominal, we refer to a rate with no adjustment. In GDP and interest, nominal remains constant but real has an adjusted value.
For example, Pearl gave her daughter Allyson $50 when she was ten years old. Allyson kept it until she became 20 years old. In this case, do we suppose that the $50 that Pearl gave to Allyson still has the same value? The answer is no because after ten years that $50 already became a subject of inflation. There are certain things that Allyson can purchase ten years ago with that $50 that she can’t buy any more after ten years. So, in this case, we cannot compare them, especially with the time difference. They are the same $50, but the value already changed. Now, what do we call this change? We can refer to it as purchasing power. Purchasing power declines over time due to certain factors like the annual inflation rate.
Explaining real in line with nominal
We have mentioned a term called real previously. How is it related to nominal? Real is the opposite and contrast of nominal. While nominal stays constant, real is the value after making adjustments leading to a more accurate measurement. Real is accurate because it is the value after being subject to inflation.
Let’s take this discussion in the rate of returns. The rate of returns refers to an investor’s total earnings. So when we say the nominal rate of return, it is only a percentage of the initial investment. In contrast, the real rate of return refers to the investor’s earnings considering the inflation rates.
For example, Archie buys stock shares worth $600. After a year, this $600 became $660. The nominal rate of return is now equal to 10%. However, this nominal rate is not very accurate since we did not put inflation into account. We have said that the purchasing power declines over time. So this percentage is most likely to drop as well in the coming one or more years. The real rate of return is not going to be 10%, but it will be lesser. Let’s suppose that the statistics say that the inflation rate is 3% for that given year, now your real rate of return is just 7%. (Nominal rate of return 10% minus inflation rate 3% is equal to 7% real rate of return)