What does it mean to be in real terms?

Understanding Real Terms: Adjusting for Inflation’s Impact

In the realm of finance, it is crucial to distinguish between nominal and real values. Nominal values represent the face value of a financial figure, while real terms account for the impact of inflation on its purchasing power.

Inflation refers to the sustained increase in the general price level of goods and services. As prices rise, the value of money decreases, meaning that a given amount can purchase less over time. This phenomenon can distort the perception of economic growth if not properly accounted for.

Adjusting for Inflation

Adjusting a financial figure for inflation involves using an inflation index, such as the Consumer Price Index (CPI) or the Producer Price Index (PPI). The inflation index measures the percentage change in prices over a specific period.

To determine the real growth or decline of a financial figure, one multiplies the nominal value by the inflation rate. For example, if sales increase by 5% and the inflation rate is 3%, the real growth rate is calculated as:

Real Growth = Nominal Growth - Inflation
Real Growth = 5% - 3%
Real Growth = 2%

This calculation reveals that while the nominal sales growth may appear impressive, the actual real growth is only 2%. This provides a more accurate reflection of the genuine economic progress made.

Importance of Real Terms

Comprehending real terms is essential for making informed financial decisions. It enables investors to assess the true value of their investments and companies to gauge their actual growth.

Central banks also use real terms to set interest rates and guide monetary policy. By considering inflation, they can ensure that interest rates are appropriate and do not stifle economic growth or contribute to excessive inflation.

Example

Consider a company that reports a 10% increase in revenue. At first glance, this seems like a significant gain. However, if inflation is running at 5%, the real revenue growth is only:

Real Growth = 10% - 5%
Real Growth = 5%

This means that while the nominal revenue increased, the company’s purchasing power only expanded by 5%.

Conclusion

Adjusting financial figures for inflation reveals the true growth or decline of an economy or business. By accounting for inflation’s impact, investors, companies, and policymakers can make informed decisions based on real terms, providing a more accurate understanding of economic conditions and market performance.