The Real and Nominal Value of Money

Gary Alder – Feb 10, 2009

If we want to move from the position of being required to individually produce everything that we consume to a situation where we can do what we do best and exchange that value for value created by those who have different talents and unique abilities, we need to develop a means of facilitating that exchange. We have to be able to determine and express comparative value. If a rancher wants to exchange a sheep for some chickens, he needs to know approximately how many chickens could be reasonably expected in exchange for 1 sheep. In a simple exchange each party could state their original position and start the negotiation from there. If the man with the sheep thought a reasonable exchange was 1000 chickens for 1 sheep and the man with the chickens thought 1 for 1 was the way to go, would you expect them to strike a bargain? Not likely.

In order to even start serious negotiation we intuitively would tell both of the above mentioned gentlemen to “get real” but what does that actually mean? However we pursue it, determining the real value of anything evades us. The real value of something has no means of expressing itself. Neither do we have the means to determine the value of something to someone else.  When it comes right down to it we are not able to accurately describe the value of anything. The value (as a noun) of any item depends upon the one who will value (as a verb) that item. 

The real value of that “something” is in fact not constant but quite variable. We all value things differently at different times and in different situations.  From this we must conclude that the real value will never be actually “real” but more of a comparative approximation of a common or usual value. Not only is the value subjective in the sense that each individual has a different value in mind, it approaches the state of being unknowable. We know that in the mind of the man with the sheep 1 chicken was not enough to entice him to trade.  We don’t know however whether 2 or 500 or 999 chickens would have sealed the deal. We might, however, know from our knowledge of similar past transactions that let us say between 25 and 40 chickens had been traded for a sheep.

The only means we have available to us of describing or comparing value is to use some standard of measurement.  This standard of measurement needs to be common to both parties in a transaction.  In the example above we actually see that separate standards were stated by the positions of the would-be exchangers.  Each used his perception of the value of the product of the other as the standard.  The man who offered the sheep for trade calculated the value of the sheep in terms of chickens, (1000).  The owner of the chickens, on the other hand, expressed the value of each of his birds in terms of sheep, (1). Neither of these proposed standards would work.

Adam Smith describes the real value as “the real [usual] quantity of subsistence which it will purchase or command.”  To give ourselves a point of reference we might use a single item of our subsistence such as a loaf of bread or a gallon of milk.  Although in practice this would be much more variable than considering all items of subsistence as a whole, it does illustrate the point quite well.  Thus we might talk about how many gallons of milk could be traded for a gallon of gasoline at one time period as opposed to another time period.

The problem in relying on a single product is that circumstance may have much more to do with price change than does time period in determining the “real” value.

Since we brought up the price of gasoline, at the current period of time (2008 – 2009) we have an example of wild price fluctuation.  We have recently seen the time that 1 gal. of gasoline could be purchased for approximately the price of 1 gal. of milk.  We then saw the price of gas rise to where you could purchase 1 and 1/2 gal. of milk.  Then the price of gas fell to where 1 gal. of gas could be purchased at the price of 2/3 of a gal. of milk.

Now that we have shown that the real value is only an approximation let us talk about the nominal value.  Nominal means in name, and thus we have a standard established for discussion.  Over time a standard of using the value of certain quantities of precious metals has been established.  The rarity, durability, and divisibility of metals such as gold and silver have proved these commodities to be excellently suited for a means of exchange, or “money.”  Another desirable feature of this standard is that it doesn’t change very much, especially in the short term.  Fixed standards serve us much better than variable ones.  Now by using the terms of the units of a monetary system we have a way to describe the value or price of all other commodities that will be understandable to both parties in any transaction. The amount of money for which something is exchanged is the nominal value or the price.

We intuitively know that in theory, theory and practice are the same, but in practice they are often very different.  What if the value of our money changes?  How do we then relate nominal price of an item in another time period to the nominal price of that item today?  We use the “real” price, even though it is only an approximation.  Using the “real” value becomes a way to re-calibrate our standard (the nominal value), so to speak

Adam Smith in his book The Wealth of Nations describes the real value of things as opposed to the nominal value.  This was done because the value of the denominations of money changed over time.  We must recognize that Adam Smith talks about values over hundreds of years.  To make things more understandable to Americans unfamiliar with British money, and to provide a decimal system based comparative scale, the pounds(l), shillings(s) and pennies/pence(d) are translated to American dollars using the approximate values found in Noah Webster’s 1828 dictionary in brackets ([ ]).

1 pound = 20 shillings = $4.4444

1 crown = 5 shillings = $1.1111

1 shilling = 12 pence = $.22222

1 penny = $.018518

In 1425, twelve shillings [$2.67 nominal] contained about the same quantity of silver as four-and-twenty shillings of our present [1773] money [$5.33 real].  An ox hide, therefore was in this account valued at the same quantity of silver as 4s 4/5ths of our present money [$1.07 real].  Its nominal price [$.53 (half of the 1773 value)] was a good deal lower than at present.  But at the rate of six shillings and eight-pence [$1.44 nominal] the quarter [8 bushels], twelve shillings [$2.67 nominal] would in those times have purchased fourteen bushels and four-fifths of a bushel of wheat, which at three [shillings] and six-pence the bushel [$.78 real], would in the present times cost 51s. 4d [$ 11.41 real].  An ox hide, therefore, would in those times [$.53 nominal] have purchased as much corn as ten shillings and three-pence [$ 2.28 real] would purchase at present.  Its real value was equal to ten shillings and three-pence of our present money [$2.28 real].  In those ancient times, when the cattle were half starved during the greater part of the winter, we cannot suppose that they were of a very large size.  An ox hide which weighs four stone of sixteen pounds averdupois [a hide which weighs 64 pounds avoirdupois (our common measure of weight)], is not in the present times reckoned a bad one; and in those ancient times would probably have been reckoned a very good one.  But at half a crown [$ .56] the stone, which at this moment (February 1773) I understand to be the common price, such a hide would at present cost only ten shillings [$ 2.22 real].  Though its nominal price, therefore, is higher in the present [$ 2.22] than it was in those ancient times [$ .53 nominal], its real price, the real quantity of subsistence which it will purchase or command, is rather somewhat lower. [Wealth of Nations p. 314]

Technically the term nominal value refers to both the former and current stated value.  It generally presupposes a monetary standard that has changed such that the same denominations of money now have different meanings.  The expression real value is generally used to translate the nominal value of a former point in time to the nominal value of the current time.  The issue that concerns us most is that the standard changes.  We wouldn’t put up with that with measurement of distance.  We want an inch, a yard, or a mile to be the same yesterday, today, and tomorrow.  Why would we accept variance when it comes to measuring value?  Because the comparative value of commodities has some natural fluctuation both individuals and governments take license.

Even though the measurement of value is not precise like the measurement of distance, volume, or weight, both individuals and governments have made changes for their own benefit to the detriment of all of the users of various monetary systems.  In the above quote from Adam Smith we find that by 1773 the silver content of the shilling had been reduced to half of the content of the shilling of 1425.  Without giving any justification for debauching the currency, we must say that this happened over a period of 348 years.  How much worse of a crime is it for that to happen over a period of only a few years?  Today in America we have to go through the same translation process when we talk of prices of only a few years ago.

“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
[John Maynard Keynes - The Economic Consequences of the Peace (1919)]

There are many ways to debauch money but they all have in common the reduction of the amount of silver or gold that the coins contain or that the paper represents.  The end result is that it takes more money to purchase each product.  We call it inflation of the price.  More accurately it is the devaluation of the money.  It destroys our ability to accurately use money as the means of measurement.  The nominal value of money ceases to serve as a standard and we go searching for ways to talk of things in terms of real value.  It generates such things as cost-of-living raises, bracket creep in the income tax system and speculation that something will be of more value tomorrow because prices are rising.

The Constitution in Article I Section 8 Clause 5 delegates establishing certain standards as congressional prerogatives. Clause 6 provides for the punishing of counterfeiting.  It lists among the responsibilities of the congress the following:

 coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;

 provide for the Punishment of counterfeiting the Securities and current Coin of the United States;

The same clause that describes the standard of weights and measures describes the standard of measuring value which is money.  Money is meant to measure value.  The way that money was initially set up was that the government was to coin the money using silver and gold.  In order to have a standard each dollar minted was to contain a precise amount of silver (371.25 grains or .77+ Troy once).  The weight and the purity of the silver were to be certified by the government.  We the people could then trust this as our standard.  Counterfeiting was to be punished.  Does that include counterfeiting by the government itself?  Is not debauching money essentially counterfeiting?  Is that not what inflation amounts to as well?

Here then is a seldom considered aspect of the separation of powers of the state and national components of the government:  If the national government is in charge of the money standard and it also puts itself in charge of the use of money to benefit one individual or class of individuals, would there not be a temptation for government to modify the standard to make it serve the specific benefit of a particular class of individuals more than being an independent standard for the general welfare of the people?  Would the temptation not drastically increase if no clear blame could be placed on the government for using money in this way?  Would not the temptation to use money in this way be increased exponentially if that use of money, or promised use of money could buy votes to keep the national government playing the sugar daddy role either by keeping the incumbent in office or replacing him with a more “generous” representative?

One more question, who can resist that much temptation with that little chance of being caught?  The answer-only a true patriot or statesman.  The Framers did not expect that everyone who got into a government position would be a statesman, so the protection was in the words of Thomas Jefferson: “bind him down from mischief by the chains of the Constitution.”  While that intuitively sounds like good advice how is it done?

Let us here remind you of key # 9 of the Keys to Understanding the Paradigm of the Founding Fathers:  The national government was to deal with the states and other nations; the states and local governments were to deal with the people.  If there were no such thing as a dole on the national level, it couldn’t be used to buy votes.  Of course if we used the method described in Article II of the Constitution to elect a president there would be no need for campaigning and promising any kind of a bribe to the people.  If the 17th amendment were repealed, we would have a state check through the Senate for largess proposed by the House of Representatives.  If the national government could not tax and then pass the money to the states for distribution, the states would have to be accountable to the people for funds taken through taxes as well as the way these funds were spent.  With a constant standard of monetary value there would not need to be a translation of nominal money amounts to “real” money amounts to determine current equivalent value.