What Does Nominal Dollars Mean?
Nominal dollars refers to the actual price of an item in dollars, during a specific year. For example, if a loaf of bread costs $4 in 2011, but it cost 35 cents in 1950, these are nominal prices. Quoting a price in nominal dollars does not consider the effects of inflation on all items. A worker who paid 35 cents a loaf for bread in 1950 also received a much smaller paycheck and made lower payments on his mortgage.
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Significance
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Real dollars are an alternative to nominal dollars. An economist calculates the cost of an item in real dollars by using the consumer price index to deflate the cost of an item in dollars. The consumer price index is an average of the prices of all items, during one year, in comparison with another year. If the consumer price index in 2011 is 20, and the consumer price index in 1950 is 1, than the $4 loaf of bread has a real price of 20 cents in 1950 dollars, so prices actually went down.
Comparison Period
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A consumer price index can be used to calculate the real price of an item in any year during the comparison period, as long as the economist knows what the item cost in nominal dollars. For example, if the consumer price index in 1970 was 5 using 1950 as a base year, then a loaf of bread that had a nominal cost of 80 cents in 1970 actually cost 16 cents in 1970 dollars. Real prices are useful to determine whether the price of an item has been increasing or decreasing over time, without considering the effects of inflation.
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Base Year Selection
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The base year of the consumer price index does not affect an item's cost in nominal dollars. If an economist decides to use 1960 as the comparison year, instead of 1950, this does not affect the price that an item actually cost in 1970. Changing the base year does affect an item's cost in real dollars if the consumer price index changed between the two comparison years.
Budgeting
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When an organization creates a budget, the organization can calculate its expenses in future years using nominal dollars. If a machine costs a certain amount in 2011, and it needs to be replaced in 2031, the organization can use the average growth rate of the consumer price index to calculate the replacement cost. If the price index changed from 15 to 20 from 1991 to 2011, this is a 33 percent increase, so the organization can predict that its nominal cost will be 33 percent higher to replace the machine in the future.
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