What is the difference between money and real money?

Understanding the Distinction Between Money and Real Money

In the realm of personal finance, distinguishing between money and real money is crucial for accurately assessing financial wealth. While nominal money holdings provide a snapshot of cash and its equivalents, real money balances offer a more nuanced understanding that accounts for the impact of inflation.

Nominal Money Holdings

Nominal money holdings represent the face value of currency, coins, and other assets that can be easily converted into cash. This includes items such as checking accounts, savings accounts, and money market funds. While these holdings provide a convenient measure of liquidity, they fail to capture the true purchasing power of money over time.

Real Money Balances

Real money balances, on the other hand, adjust nominal money holdings for the effects of inflation. Inflation erodes the purchasing power of money, meaning that goods and services become more expensive over time. To account for this, real money balances divide nominal holdings by the inflation rate.

By considering the impact of inflation, real money balances provide a more accurate picture of financial wealth. They reflect the true amount of goods and services that can be purchased with the available money.

Example

Consider an individual with $10,000 in a savings account in 2023. If the inflation rate for that year is 3%, the individual’s real money balance would be $9,709. This adjusted balance reflects the fact that the purchasing power of the $10,000 has diminished due to inflation.

Importance of Real Money Balances

Understanding real money balances is essential for:

• Tracking inflation: Real money balances provide a clear indication of the impact of inflation on one’s financial wealth.
• Planning for the future: By considering real money balances, individuals can make informed decisions about investments and retirement savings.
• Protecting purchasing power: Real money balances help individuals ensure that their wealth retains its purchasing power over time.

Conclusion

While nominal money holdings may provide a surface-level view of financial wealth, real money balances offer a more accurate representation that accounts for the effects of inflation. By understanding this distinction, individuals can make informed financial decisions, protect their purchasing power, and plan for the future effectively.