Imagine A very simple country where only bread is produced and the production of bread requires labor and capital. Let say price of bread in this simple economy is 20 rupees. We also initially assume that the worker who are providing labor are paid a wage of 10 rupees per hour. If the firms increases prices of bread by 20 rupees it now receives more revenue. So the firm decides to keep the worker happy by increasing their wage from 10 to 15 rupees. How much did the workers gained?
The worker haven't gain anything instead they have lost. Look at their wages in terms of bread they are earning instead of rupees, or how many breads they can buy with their wage. Initially their wage was 0.5 breads (half bread) and now 0.37 bread which is less than half. So in reality their wage has decreased.
The wage in terms or rupees is nominal variable. The wage in terms of bread is the real wage. Economist are mostly concerned with real variables.
From this discussion we can form our general definitions
Real Variable: variables measured in terms of goods.
Nominal Variable: variables measured in terms of monetary units.
Real and nominal variables are related in the following manner
Real Variable = Nominal Variable / Price Level
or
Nominal Variable = Real Variable X Price Level
Check these formulas for the above example of wages in terms of bread. The commonly occurring real and nominal variable in economics are interest rate, wages, rents and national income measures like GDP.
Real GDP vs Nominal GDP
we have discussed how we calculate real and nominal variables but this rule is slightly modified for GDP though the concept is the same. GDP by definition is the 'monetary value of goods and service'. So both real and nominal GDP will be a monetary figure. But the basic formula is the same
Real GDP = Nominal GDP / GDP Deflater
Here GDP Deflater is equivalent of Price Level (CPI) with a little bit of difference.
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