Nominal versus Real, Part 1: Definition of Monetary Exchange

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.

The government buys a good from the private sector

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.

Paying taxes is a nominal transaction.

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.

Buying a bond is a nominal transaction

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.

The repayment of a bond is also a nominal transaction

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).

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Nominal versus Real, Part 1: Definition of Monetary Exchange

5 thoughts on “Nominal versus Real, Part 1: Definition of Monetary Exchange

  1. vimothy says:

    I think you’re misunderstanding this.

    The difference between real and nominal is not the difference between flows of paper and flows of output.

    Recall that aggregate expenditure = GDP

    In any period there will therefore be a flow of money from the demand side to the supply side, and a flow of output from the supply side to the demand side.

    The difference between real and nominal is the difference between the value of these flows (which are equal by definition) at current vs constant prices.

    The nominal flow of money is equal to the nominal flow of output, and the real flow of money is equal to the real flow of output.

    1. Vimothy,

      I am saying that the economists are not modeling monetary exchange properly.

      Perhaps I am not saying it in the right way, though.

      For example, if the King comes to take a chicken, then that is a tax in a barter economy. But in a monetary economy, taxes are paid with money, not chickens. If the King comes to take money, and not chickens, then all that happens is that prices decline, correct?

      Real output remains the same (abstracting away from monetary effects).

      Now you can argue that the king will only come to take money if he wants to also buy a chicken. But that means in a monetary economy, a real tax is government purchase of output.

      Whereas tax on money is basically monetary policy.

      Now you can equate the tax with purchase of output only under certain conditions: that all taxes receipts result in simultaneous purchases of output, and purchases of output only arise from taxes. With all of these assumptions, you can talk about taxes in real terms and argue that fiscal policy has no effect on prices.

      But none of those conditions hold, in practice.

      So if your definitions are switched, then you will get the wrong policy prescriptions.

      Similarly, if you define production as income, then you will think that taxes on income are taxes on production, which they are not. Then you will derive efficiency results for taxes on income that only hold in a barter economy, but which do not hold in a monetary economy. Then you will conclude that taxes on capital income are inefficient, because you are confusing taxes on capital income with real taxes on capital (e.g. that decrease the stock of capital).

      Etc.

      But perhaps I haven’t been communicating this well.

      1. Or perhaps a better way to think about this is that you cannot take a flow of money, divide by the price of goods, and get a flow of goods. It’s still a flow of money and not goods, it is not a “real” flow. And the problem with dividing by the price of goods is that the flow of money determines the price level. In a monetary economy, the flows of money need to be treated separately, as their own objects of study. You cannot only look at the flows of goods, irrespective of whether people, in the end, only care about goods.

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