The observation that we use money to buy things tells us more about the value of money. Economists often make a distinction between real and nominal values; this distinction can be applied to money as well. First, what is the nominal value of money? This is almost a trick question: we are asking, “How many dollars is a dollar bill worth?” The answer, which does not require a doctorate in economics, is that a dollar bill is worth $1.
Nominal variables—those measured in dollars or other currencies—can be converted into real variables—that is, those measured in units of real gross domestic product (real GDP). To convert a nominal variable to a real variable, we simply divide by the price level. For example, if your nominal wage is $20 per hour and the price level is $10 (meaning that a typical unit of real GDP costs this amount), then your real wage is 2 units of real GDP.
Toolkit: Section 16.5 "Correcting for Inflation" If you want to review the process of correcting for inflation, you will find more details in the toolkit.
Exactly the same principle can be applied to money itself. The real value of a dollar is obtained by dividing one by the price level. Thus
Think of an economy in which real GDP is measured in pizzas and suppose the price level— the price of a pizza—is $10. Then the value of a dollar bill is 1/10 of a pizza.
Although $1 is always worth $1, you are not guaranteed that the dollar bill in your pocket will buy the same amount of goods and services from one day to the next. If your local café increases the price of a cookie from $1.00 to $1.25, then your $1 will no longer buy you a cookie; its value, measured in cookies, has declined. If the price level increases, then the real value of money decreases. For notes and coins to be a good store of value, it must be the case that prices are not increasing too quickly. [***We discuss this problem in more detail in Chapter 11 "Inflations Big and Small".***]
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