In a monetary exchange economy, people sell goods for money, and they buy goods for money. Flows of money are nominal flows. Flows of goods are real flows.
I’ve depicted real flows in red and nominal flows in blue. A barter economy would be one in which red is exchanged for red. A monetary exchange economy can have red exchanged for blue, or blue exchanged for blue, but it cannot have red exchanged for red.
It is the blue exchanged for blue that confuses people the most.
The flows of goods also affect balance sheets. You do not need two arrows in all cases. Often it is enough to have a single arrow, combined with a change in the balance sheets. It is really about balance sheet adjustments, not transactions per se.
Balance sheets contain both real and nominal assets.
A real asset, for example, is a house, or a capital good.
A nominal asset is an IOU to deliver a stream of money. For example, a bond or a share of stock.
Nominal assets are not real assets. If you are confused, one clue would be to try to weigh the asset. Nominal assets typically exist in electronic or paper form. Real assets tend to be heavy. A scale can be used to help you distinguish between nominal and real assets, until you get the hang of it.
An example of a nominal balance sheet adjustments is when a household pays taxes. It extinguishes its tax liability and makes a nominal transfer to the government. This is a nominal transaction, not a real transaction, that affects the nominal part of the balance sheet.
Another example of a nominal transaction is when a household buys a government bond. Note that buying a bond is not the same as buying a truck. You can tell that this is a nominal transaction because all the arrows are blue. That means paper is being exchanged for paper.
When the bond is extinguished, the government provides money to the bondholder, whose bond now matures (a kindly of way of saying that dies 🙂 ).
Don’t be confused into thinking that the bond holder now owns a truck. Or a piece of fruit. He is supplied with money because of the blue arrow.
Many find this difficult to believe, as the “purpose” of getting more money is to spend it on consumption goods, therefore receiving money must be the same as receiving consumption goods.
This is what is known as a category error. For example, many people believe that the purpose of buying consumption goods is to receive pleasure, but goods are not the same as pleasure, or utility.
There is a whole messy relationship between goods and utility.
If we defined goods as being equal to utility, then we would run into a lot of conceptual and theoretical problems.
Similarly, the purpose of buying a car may be to get a girlfriend. But buying a car is not the same as getting a girlfriend. It’s important for economists not to confuse cars with girlfriends, or shares of stock with trucks.
In a monetary economy, money (and nominal issues) become important for their own sake. It may appear that the purpose of getting money to buy consumption goods. But that cannot be the case. The ultimate purpose is to maximize pleasure over the life of the person. Even ignoring Plato’s observation that as soon as you introduce money, people begin to seek it for its own sake, it is still the case that whenever money can be used to purchase bonds, capital goods, consumption goods, or extinguish debt, then the money price of consumption goods, capital goods, and bonds, will be determined by the relative eagerness of the public to do all of the above. Even if we assume that it is ultimately about lifetime consumption, this done not mean that each point in time, the value of money is measured only in terms of the number of consumption goods it can buy.
And an additional wrinkle is put on this once you assume overlapping generations. It can be that each generation is maximizing lifetime consumption with some strategy, say, of incurring debt, purchasing capital selling capital, etc with the ultimate goal of maximizing lifetime consumption, nevertheless, the market aggregates all these strategies at each point in time, giving money a value that diverges purely from the amount of consumption goods it can purchase at that time, and this divergence can be permanent due to the overlapping generations. Roughly speaking, the value of money never “converges” to its ultimate consumption value even if it converges for each generation.
This is an emergent phenomena. But in order to allow this phenomena to emerge — in order to study it — we have to model the transactions as they actually occur — with money — and not conflate nominal flows with real flows, or nominal stocks with real stocks. Dividing by the consume price index does not convert a nominal stock (or flow) into a real stock (or flow).