You may have heard economics or business leaders referring to the term "nominal wage" and wondered what they mean. The easiest way to understand a nominal wage is as simple dollar value. It's basically the amount (in dollars) that an employee is paid for their work. To really understand a nominal wage, though, it's necessary to think about the difference between "nominal" and "real" value--the difference between a dollar amount and what that dollar amount is actually able to purchase on the market.
Money is Variable
Typically, when we think about money in an economic system, we don't think of it as a commodity, like rice or potatoes, but rather as a constant. This is because money is merely the commodity that everything else is priced in terms of--it's a universal commodity. In other words, while it's unusual to talk about a potato's value in terms of rice, it's fairly regular to talk about a potato's value in terms of money. The problem with this, though, is that money is kind of a commodity too: It has a supply and demand, and it can gain or lose value under certain economic conditions. Actions by the government and central banks control the "supply" of money, and the prices of the things we buy can rise or fall according to how much money is available in the system.
Value of Money and Wages
If we understand money as a varying--rather than fixed--commodity used to price other goods, it's a little easier to explain why there must be a distinction between "real" and "nominal" wages. Changes in the amount of money available in the system have the ability to impact wages in drastic ways. In the United States, the supply of money is mostly regulated by the central banking system, called the Federal Reserve.
The Federal Reserve can make decisions--like lowering interest rates--that grow or shrink the supply of money. If they decide to expand the money supply, money becomes easier to obtain through loans, and employers might be able to afford to pay employees more. Wages will rise if the money supply increases.
Declining Value of Increasing Wages
Generally speaking, larger wages would seem like a good thing. Everyone wants a nice raise. The problem with rising wages that are caused by an expansion of the money supply, though, is basically that everyone's wages increase. Instead of a single worker getting paid more, everyone in the economic system finds themselves with a raise.
Expressed another way, if we think of "dollars" as a commodity like rice or potatoes, the increase in the availability of dollars makes them less valuable, just as a bumper crop of rice would make it less valuable. Because dollars are worth less than they were before, it takes more of them to purchase the same amount of employee time. This is a phenomenon known as wage inflation, and it can have a tremendous effect on the larger economic system.
Wage Inflation and Nominal Wage
While the relationship between wages and prices is believed to be fairly complex, it's easy to understand why decreases in the value of money could be a serious problem. For example, imagine you get a raise and instead of being paid $10 an hour, you're now paid $20 an hour. This would mean an increase in your "nominal wage"--the amount of money, expressed in dollars, that you're paid per hour.
But this is only a good thing to the extent it enables you to buy more commodities--for instance, with an hour's worth of wages, you can now buy two movie tickets instead of one. The value of your hour of work expressed in other commodities--like movie tickets--is called the "real wage," the amount labor is worth in terms of other goods for sale on the market place.
Real and Nominal Wages
At this point, it's important to underscore the concept of "nominal wage" as distinct from "real wages." It's possible that the dollar value of a wage might increase--from $10 to $20 an hour--but the price of everything else might increase as well--for example, a movie ticket that cost $10 also now has increased to $20. This is actually a fairly common problem.
Even though you're getting paid more in terms of dollars, the amount of stuff that can be bought for those dollars has stayed the same. In this case, you'd experience an increase in nominal wage, but your real wage--the amount your pay in dollars is actually worth--would stay the same.
- "Macroeconomics"; Paul Krugman and Robin Wells; 2005
- The New School: The Issue of Money Wages
- Federal Reserve Bank of Cleveland: Does Wage Inflation Cause Price Inflation?
- Federal Reserve Bank of Dallas: Deflating Nominal Values to Real Values
- euro cent image by AGphotographer from Fotolia.com