Nominal balances

What Is Nominal balances?

Nominal balances refer to the face value of a quantity of money, financial assets, or economic indicators that have not been adjusted for changes in the purchasing power of money over time, such as due to inflation or deflation. In the realm of monetary economics and macroeconomics, understanding nominal balances is crucial for distinguishing between changes in value caused by price movements and changes caused by actual shifts in quantities or economic activity. For instance, the amount of cash in a wallet or the stated value of a bank account balance represents nominal balances. They reflect the literal numerical value without considering what those numbers can actually buy.

History and Origin

The distinction between nominal and real values became increasingly important with the formalization of economic thought, particularly as economists sought to understand the effects of monetary phenomena on the real economy. Early economists, such as Irving Fisher, extensively explored the relationship between the quantity of money and its purchasing power. Fisher's seminal 1911 work, "The Purchasing Power of Money," was instrumental in establishing frameworks that differentiate between nominal quantities and their real equivalents, especially in the context of price level changes and their impact on debt, interest, and economic stability.⁴ This foundational work helped to solidify the understanding that while nominal balances might change, their true economic significance depends on their purchasing power, which can be eroded by inflation.

Key Takeaways

Nominal balances represent the unadjusted, face value of money or economic figures.
They do not account for changes in the general price level or the purchasing power of currency.
Understanding nominal balances is fundamental for accurate economic analysis, especially when contrasted with real balances.
Central banks and policymakers often monitor nominal balances, such as the money supply, to gauge monetary conditions, though their impact is often viewed through the lens of real effects.
Fluctuations in nominal balances due to inflation can create a "money illusion," where individuals or businesses perceive themselves to be wealthier, even if their actual purchasing power has declined.

Formula and Calculation

While nominal balances themselves are the raw, unadjusted figures, their significance is often highlighted when compared to "real balances," which adjust for the price level. The calculation to derive real balances from nominal balances involves dividing the nominal amount by a relevant price index.

The formula for real balances is:

\text{Real Balances} = \frac{\text{Nominal Balances}}{\text{Price Level (or Price Index)}}

Where:

Nominal Balances ((M)) represent the absolute quantity of money or a given economic variable measured in current currency units.
Price Level ((P)) is a measure of the average prices of goods and services in an economy, often represented by a Consumer Price Index (CPI) or GDP Deflator.
Real Balances ((M/P)) indicate the purchasing power of the nominal balances, showing the quantity of goods and services that can be bought.

For example, if you have a nominal balance of $100 and the price level is 1.0 (base year), your real balance is $100. If inflation causes the price level to rise to 1.05, your real balance falls to approximately $95.24, even though your nominal balance remains $100.

Interpreting Nominal balances

Interpreting nominal balances requires recognizing their inherent limitation: they do not reflect the true economic value over time due to changes in the value of money. For instance, a person's nominal wage might increase by 3% in a year, but if inflation is 5%, their real wage (and thus their purchasing power) has actually decreased. Economists and financial analysts use nominal balances for immediate, current-period measurements of transactions or assets. However, for meaningful comparisons across different periods or to understand actual changes in economic well-being or economic growth, these nominal figures must be "deflated" using a relevant price index to convert them into real terms. Without such adjustments, data based solely on nominal balances can be misleading regarding actual economic performance or individual wealth.

Hypothetical Example

Consider an individual, Alice, who keeps her savings in a checking account. At the beginning of 2023, Alice has a nominal balance of $10,000 in her account. Let's assume the price index for the goods and services Alice typically buys is 100 in 2023 (serving as a base year). Her real balance is therefore $10,000.

Throughout 2023, there is a period of significant inflation, and by the end of the year, the price index has risen to 105. Alice has not deposited or withdrawn any money, so her nominal balance remains $10,000. However, to find her real balance at the end of 2023, we apply the formula:

\text{Real Balance}_{2023} = \frac{\$10,000}{105/100} = \frac{\$10,000}{1.05} \approx \$9,523.81

Despite her nominal balance remaining $10,000, Alice's real balance, or the actual goods and services her money can buy, has effectively decreased to $9,523.81 due to the rise in prices. This example illustrates how nominal balances, without adjustment, can obscure a decline in real purchasing power.

Practical Applications

Nominal balances are routinely reported and used in various economic and financial contexts, serving as the basis for further analysis. Central banks frequently refer to nominal monetary aggregates, such as M1 or M2 money supply figures, which represent the total face value of currency and deposits in circulation.³ Governments and international organizations like the International Monetary Fund (IMF) publish nominal Gross Domestic Product (GDP) figures, which represent the total market value of all final goods and services produced within a country in current prices.² These nominal figures are essential for understanding the current scale of economic activity and monetary flows. Businesses also deal with nominal balances daily, from recording sales revenues and expenses to managing nominal wages and nominal debt obligations. However, for long-term strategic planning or cross-period comparisons, these nominal figures are often converted into real terms to account for changes in price stability.

Limitations and Criticisms

The primary limitation of nominal balances is their inability to accurately reflect changes in true economic welfare or output over time when the price level is not stable. An increase in nominal balances could simply be a result of inflation, giving a misleading impression of growth or increased wealth. For instance, if a country's nominal GDP increases by 5%, but inflation for that period is 7%, the real GDP has actually contracted, indicating a decline in actual production and living standards.¹ This phenomenon, sometimes called "money illusion," can lead individuals and policymakers to make suboptimal decisions based on unadjusted figures. Economists and analysts often criticize the sole reliance on nominal data for long-term or comparative analysis, advocating for the use of real data to provide a more accurate picture of economic trends and performance. In periods of high hyperinflation, nominal balances become almost meaningless as their purchasing power deteriorates rapidly.

Nominal balances vs. Real balances

The fundamental distinction between nominal balances and real balances lies in their adjustment for the price level. Nominal balances represent the unadjusted, current-dollar (or other currency) value of a financial quantity, such as cash holdings, bank deposits, or a nation's financial assets. They are the numbers written down or displayed. In contrast, real balances are derived by adjusting nominal balances for changes in the overall price level, thereby reflecting the actual purchasing power of those balances. For example, if you have $500 in your wallet, that is a nominal balance. If prices double, your nominal balance remains $500, but your real balance (what you can buy with that $500) is halved. Economists emphasize real balances for assessing true economic well-being and for understanding how monetary policy affects the real economy, free from the distortions of price changes.

FAQs

What causes nominal balances to change?

Nominal balances can change due to various factors, including new money being printed and circulated by a central bank, deposits and withdrawals from bank accounts, income earned, or the purchase and sale of assets. For broader economic measures like nominal GDP, changes can reflect increases in the quantity of goods and services produced, increases in their prices, or a combination of both.

Why is it important to distinguish between nominal and real balances?

Distinguishing between nominal and real balances is crucial because nominal figures can be misleading in the presence of inflation or deflation. Real balances provide a more accurate representation of actual purchasing power and economic activity, allowing for meaningful comparisons over time and a clearer understanding of changes in living standards or productive capacity. For example, understanding the Fisher effect requires differentiating nominal from real interest rates.

Are nominal balances relevant in a stable economy?

Even in an economy with relatively stable prices, nominal balances are still the direct measure of current transactions and monetary holdings. However, their distinction from real balances becomes less pronounced when inflation is low or negligible, as the erosion of purchasing power is minimal. Nonetheless, for academic rigor and precise economic analysis, the distinction remains important, especially for understanding the long-term implications of the quantity theory of money.