Finance for non-finance 1: Understanding real growth

Some of the very basic things that a finance or economics student studies can be quite baffling to people who have not studied these subjects. However, it is of utmost importance that people understand these concepts because they influence their everyday life and happiness considerably. I would try to write on a few of these issues in basic terms.

I think the concept of ‘Real Growth’ vs ‘Nominal Growth’ is one of the most important concepts to fully understand. To explain this let me use an example. Let’s assume that a fresh graduate is earning 10,000 taka per month. At the end of the year his boss gives him a raise of 10%. In nominal terms his income has increased 10% to 11,000 taka per month. However, the important question is whether he is ACTUALLY richer? To know that we need to know whether prices of goods and services have increased or not. Originally, he was able to buy groceries, pay rent, eat out with friends with his 10,000 taka salary. Now, these have increased in price and buying the same quantity of stuff would need 12,000 which is a 20% increase.

This means that in ‘real’ terms he is not richer but poorer. He cannot sustain his earlier living standard with his increased salary of 11,000 per month. So in economic terms we say that his nominal income grew 10% but real income declined by 10% (20%-10%).

As human beings we are always be more concerned with ‘real’ changes and not ‘nominal’ ones. This is why we are more concerned with ‘Real GDP Growth’. Companies need to be able to increase prices of their products by the cost inflation to be able to maintain profitability.

Let us look at it from another perspective. Why does bond and stock prices go up when interest rate falls? That is because interest rate declines are usually associated with decline in inflation. So a bond which gave 10% return (when inflation was 7%) will see its price go up when inflation comes down to 4%. This is because, the real return from the bond is now 6% versus 3% earlier. With the cash flow from this same bond we can buy more goods and services.

Summary

1. Real growth matters much more than nominal growth
2. Higher inflation reduces real growth
3. Stock and bond prices go up when interest rates come down as real returns are increasing

Asif Khan, CFA

Asif Khan is presently a Research Analyst (Financial Sector) for Exotix which is a frontier market focused investment bank. He has more than 6 years of work experience as equity analyst in both buy and sell side roles across Asian frontier markets. Asif is a CFA Charterholder and has a dual major in Finance & Economics from North South University.

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