After all this talk about inflation over the last few weeks, you’re probably left wondering what your money’s really “worth”. Funny enough, when discussing inflation, there is literally a term that refers to this real value, and is aptly referred to as... “real value”. The idea of real value is important because it helps eliminate the guesswork when calculating the impact of inflation on your dollars. Real value refers to the actual amount of goods and services your dollar can buy, while nominal value, the opposite of real value, refers purely to the dollar amount of money you have, not its purchasing power. In this article, I’ll be exploring these two concepts.
Real value measures the purchasing power of a dollar, and adjusts for inflation. It’s most commonly used to measure the actual impact of things like changes in income - showing whether an increase in income is simply due to inflation or realized factors like company/employee performance.
Why is this important? Well, it allows you to see if you’re actually getting a raise when working/if you're actually earning more money, rather than just getting an increased dollar amount that has the same purchasing power as what you were making earlier.
To make this clearer, let's use an example. Let’s say during your first year working, you made $80,000. At the same job, in your second year, you get promoted, and your new salary is $84,000. This is a raise of 5%. You’re really excited, because a promotion means you're doing well.
However, you also notice that inflation has been in the news a lot. It turns out inflation was at 6% (unusually high) during the time you got promoted.
In this situation, you actually lost money! This is because while your nominal income increased (the actual dollar amount went up from $80k to $84k), the real value has gone down. Your income increased by 5%, while inflation was at 6%, meaning the purchasing power of your money went down by 6%, so your real increase was actually -1%! So, while the amount of money you made may have gone up, the price of goods and services around you actually went up, so your money was able to buy less than it originally could. This means things like gas, bread, haircuts, and other everyday items went up in price by around 6%.
While your raise, in this situation, helped mitigate the effects of inflation to an extent, it wasn’t a “real” raise, meaning that the increase in pay was not actually an increase, when accounting for inflation. The same basic principle can apply to investing too. If you invest in a stock that increased in value by 20% over 10 years, and inflation averaged 3% per year over that same 10-year span, not only did your investment produce no real profit, but also led to a negative real balance because the returns it provided were not enough to completely mitigate the effects of inflation. So, while the nominal value of your investment may have increased by 20%, the real value of your money decreased.
In short, if your investment doesn’t provide returns at, at minimum, the same rate as inflation, it will not produce any real profit, meaning the dollar amount may go up, but the purchasing power will go down.
To summarize, the real value or real rate of return accounts for inflation, meaning it shows the amount you made after adjusting for inflation. This value shows the actual amount of goods and services you can purchase with your money, rather than just the number. So, if you got a 5% raise, but inflation was 3%, you got a real return of 2%. Nominal value, on the other hand, does not account for inflation and simply tells you the percentage your money grew (5%).
I hope you found this article interesting and learned a bit more about inflation and how you can measure growth more accurately. Thanks for reading, and I’ll see you next week!