Nominal Variables

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

real value of money = 1

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price level .

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. [1] Using Money to Make Money: Arbitrage An old joke has it that the secret to getting rich is very simple: buy at a low price and sell at a high price. So another use of your $100 would be to buy goods not to consume but to resell—a process known as arbitrage. Suppose you discovered that a particular model of digital camera could be bought much more cheaply in Minneapolis, Minnesota, than in Flagstaff, Arizona. Then you could purchase a large number of cameras in Minneapolis, load them into a suitcase, fly to Flagstaff, and sell them for a profit. If the gap in price were large enough to compensate for your time and travel costs, then this would be a money machine. By buying cameras at a low price and selling them at a high price, you could make as much profit as you wished. This situation would not persist. You, and other entrepreneurs as well, would start to bid up the price of cameras in Minneapolis. Meanwhile, the increased supply of cameras in Flagstaff would cause prices there to decrease. Before too long, your money machine would have dried up: the gap between the Flagstaff price and the Minneapolis price would no longer justify the effort.