Theory: Real Prices Versus Nominal Prices

Microeconomics: Real versus Nominal Prices

Often in economics we want to compare the price of a good today with what it was in the past or in some cases, what it is likely to be in the future. For a relevant comparison, we need to be able to measure prices with respect to an aggregate price level.

Take for example the price of a dozen eggs. In absolute terms, 50 years ago its price was much lower. However, in relative terms it is lower. So we must be take care to correct for inflation when comparing prices over a time period. This is why we compare prices in relevant REAL terms rather than NOMINAL terms.

We can therefore say that the nominal price for a good is its price, not adjusted for inflation. Following on from that we consequently say that the real price of a good is its price relative go an aggregate measure of prices i.e. prices adjusted for inflation.

There are a few main aggregate measures of prices. These are the CPI, RPI and PPI.

For consumer goods, the measure used is the CPI – Consumer Price Index. It is calculated by surveying retail prices and it records how the cost of a large basket of goods that are ‘typically’ purchased by the ‘typical’ consumer varies over time. Therefore, we say that the percentage changes in CPI measure the rate of inflation of an economy.

On the other hand, for the prices of raw materials and prices of finished products sold by firms, we use the PPI – Producer Price Index. It is calculated by surveying wholesale prices and how they vary over time. Therefore, we say that the percentage change in PPI measure the rate of cost inflation and will likely predict, or at least represent, changes of CPI in the future.

WHICH ONE TO USE? If you are examining a product/ service typically bought by consumers then use the CPI. On the contrary, if you are examining a product typically bought by businesses then use the PPI.

It is common practise then to refer to prices in real terms than it is to in nominal terms. Stating all prices in real terms (adjusting for inflation) makes it easier to evaluate relative prices. So, even though we will measure prices in terms of its currency we want to think about the currency in terms of its real purchasing power.

If you fancy learning more about economics and the financial world around you check out my other articles on my blog: http://insighteconomics.blogspot.co.uk/

Thanks for reading and if you have any queries please email me at:samandchrisshapley56@gmail.com or post a comment on the page itself and I’ll try to get back to you as soon as I can.