Macro: The real subject is nominal

Happy 4th of July to everyone—especially to my stepfather, who earned a Purple Heart in Okinawa.

Consider the following two definitions of macroeconomics:

1. Macro is the study of aggregate economic variables, including inflation, real output, unemployment, interest rates and exchange rates.

2. Macro studies the effects of the market for the medium of account, in a world of nominal contracts.

The first definition is more conventional, but I find the second to be more useful. Before explaining why, consider the following analogy:

Suppose the global oil market has a monopoly supplier of barrels. Each barrel is exactly 42 gallons. Now suppose the barrel company becomes more erratic. During one month the barrels are only 40 gallons. Another month they are 45 gallons. The size moves around according to a random walk.

If all oil were traded in spot markets, then that would be a mild inconvenience, but nothing more. Prices per barrel would adjust to reflect changes in the size of barrels. Price per gallon would be unaffected.

If oil was also traded in futures markets, and continued to be priced per barrel, then fluctuating barrel size would cause major problems for the oil majors. They would hire a bunch of experts to study the monopoly supplier of barrels, trying to forecast whether the next batch would be larger or smaller than the current batch of barrels.

Part II: A monetary economy

In a simple barter economy, it’s not clear that macro would even exist, at least in its present sense. Economics would be the study of a bunch of individual markets, focusing on the relative prices of each good. At best, there would be a field called “growth theory”, which would contain a small portion of modern macro.

Now let’s consider switching from barter to an economy where silver is the medium of account. The term numeraire is often used for medium of account; it is the good in terms of which all other prices are measured. Because the current price of silver is just under a dollar per gram, I’ll assume that this country uses grams of silver as the measuring stick of value. One gram of silver is a “dollar”. Silver is the medium of account; dollar is the unit of account.

Is that enough to create a need for macroeconomics? It depends. If people did not suffer from money illusion, they presumably wouldn’t care at all about “inflation”. All people would care about is real or relative prices, which are not directly impacted by the choice of the medium of account. I suppose you could create the field of macro to satisfy the curiosity of some oddball that cares about the “cost of living”, aka the “price level”, in terms of silver. But most rational people simply would not care.

But if you add money illusion, then everything changes. People stop thinking in terms of relative prices, and instead focus on nominal prices—i.e., prices measured in terms of silver. The discovery of a massive silver hoard at Potosi would cause nominal prices to rise significantly—voters would become upset about “inflation” (meaning depreciation in the relative price of silver.)

Money illusion also causes people to negotiate long-term labor contracts in nominal terms. Now shocks to the silver market don’t just affect the “price level”, they cause cycles in employment and output. And the existence of long-term nominal financial contracts means that silver market shocks also causing financial turmoil. As a result, silver market shocks lead to both changes in the overall level of real income and the redistribution of existing income. Suddenly, unstable nominal variables are a BFD.

In one sense, silver is not that important—just one good out of tens of thousands that are traded in the economy. But if silver is one side of each of the billions of transactions that take place each year, it becomes very important. Thus while in a real sense silver would be a tiny fraction of the economy, in a nominal sense it would be 50% of GDP. Half of the entire economy!

Without money illusion and nominal contracts, no one would pay much attention to silver, despite it representing one side of almost every transaction. But if there are lots of contracts written in silver terms, and if the silver market is subject to “shocks”, then people would care a great deal about what’s happening to the nominal (silver) economy.

That’s why I believe that macro is basically a study of the implications of changes in the value of the medium of account in an economy with long-term contracts that are denominated in nominal terms.

And if it isn’t, it should be.



30 Responses to “Macro: The real subject is nominal”

  1. Gravatar of mbka mbka
    4. July 2024 at 17:17


    you still got it. The oil barrel analogy especially: that was the single most brutally brilliant thing I ever saw to explain things that nearly no one manages to explain.

  2. Gravatar of Philo Philo
    4. July 2024 at 18:40

    Judging by this post, ‘money illusion’ is an inapt term for *embracing a monetary economy* or *accepting a numeraire.*

  3. Gravatar of Solon of the East Solon of the East
    5. July 2024 at 00:31

    Although even orthodox macroeconomists often disagree, even on fundamental issues, I think the art has a lot to offer.

    But sometimes structural impediments, and culture, can render orthodox macroeconomist diagnosis…well, not in the ballpark.

    Orthodox macroeconomists remind me of an old baseball joke: A manager’s team just lost its last three games by scores of 17-13, 11-9, of 14-12, which was an extension of a season-long pattern.

    Asked by a reporter what the team needed to win, the manager replied, “We need some real power hitters.”

  4. Gravatar of Junio Junio
    5. July 2024 at 03:01

    A little late, but happy 4th of July, Scott. I am saving this post for later.

  5. Gravatar of Todd Ramsey Todd Ramsey
    5. July 2024 at 05:08

    mbka, +1. Scott’s analogies are creative genius.

  6. Gravatar of Michael Sandifer Michael Sandifer
    5. July 2024 at 07:43

    Being in a graduate econ course that’s teaching old Keynesian macro is surreal. It’s very interesting that there’s absolutely no evidence presented for the approach. I think that’s because it doesn’t exist. I keep checking.

    Does anyone see a Keynesian relationship between the US federal budget balance and NGDP or RGDP, for example? I sure don’t.

  7. Gravatar of Travis Allison Travis Allison
    5. July 2024 at 09:11

    A few questions, Scott.

    1. Could you explain how you got the “50% of GDP” number?
    2. What long-term contracts do you consider most important?
    3. I assume that you are considering wages in the category of contract. Is that an implied contract? Because usually there isn’t a legal commitment to pay a particular wage.

  8. Gravatar of ssumner ssumner
    5. July 2024 at 09:51

    Thanks mbka and Todd.


    1. I just mean that money is one side of each transaction. I probably shouldn’t have used the term GDP, as it isn’t really “production”. More like 50% of gross sales.

    2. I think wage contracts are the most important, with financial contracts coming second.

    3. It’s partly implied and partly actual. I was always on 12 month contracts, and that was true of most other people I knew—so they were pretty common. But even nominal wages not on 12 month contracts are pretty sticky due to money illusion.

  9. Gravatar of technosentience technosentience
    5. July 2024 at 12:04

    Another +1 to mbka.

    A naive solution to the presented problem would be to make the oil company standardize its barrel size, or require the central bank to keep the price level constant. I wonder how NGDP targeting fits into this analogy.

  10. Gravatar of anon/portly anon/portly
    5. July 2024 at 12:44

    “The size moves around according to a random walk.”

    “They would hire a bunch of experts to study the monopoly supplier of barrels, trying to forecast whether the next batch would be larger or smaller than the current batch of barrels.”

    Great post, but how can one forecast a randomly determined outcome? (I’m undoubtedly overlooking something).

    I think the barrels should remain the same size and instead the government changes the definition of a gallon from month to month, with prices required to be per gallon. (More realistic).

  11. Gravatar of ssumner ssumner
    5. July 2024 at 13:42

    technosentience, I actually view NGDP targeting as closer to a stable barrel (and stable nominal wages may be closer still.) People who draw up nominal contracts care more about future NGDP than future price levels.

    anon/portly, Random if forecasts are based solely on the previous path of barrel size. But other observable factors may allow some ability to forecast barrel size.

  12. Gravatar of BJH BJH
    5. July 2024 at 14:08

    +1 that the oil barrel analogy is fantastic

  13. Gravatar of Kangaroo Kangaroo
    5. July 2024 at 17:03

    Scoott: I’m going to stop short of “creative genius”. Cool post though. 🙂

  14. Gravatar of ssumner ssumner
    5. July 2024 at 17:06

    Kangaroo, Creative mediocrity?

  15. Gravatar of Edward Edward
    6. July 2024 at 00:39

    Good post. But your definition is too narrow.

    The conventional definition encompasses a broader array of economic variables such as inflation, real output, unemployment, interest rates, and exchange rates. These variables are important for understanding the overall performance of an economy.

    It’s also important to recognize that in a modern economy, both real and nominal variables interact. Real wages, for instance, are crucial for understanding the standard of living, and real output growth affects employment and income distribution, aspects which are not fully captured through your nominal lense.

  16. Gravatar of Kangaroo Kangaroo
    6. July 2024 at 05:32

    “Kangaroo, Creative mediocrity?”

    Not at all. But genius? Is everything that’s novel and useful “genius”?

    I’m reading a book about the maritime history of the world. Think of the first use of a sail. Was it “genius”? Or did it, at some point, given existing knowledge and materials, become more or less obvious to many people at more or less the same time that the wind could probably move a boat?

    Or evolution. Wallace or Darwin? In reality, both and neither. Various precursors had been around for a long time and it was first the emergence of Linnaen taxonomy, which provided a formal framework for understanding species relationships, followed by world-wide sea-going voyages, which filled up the framework with the many variations of life forms, that allowed a formal theory of evolution to emerge. Wallace and Darwin of course had some useful knowledge and education but beyond that their “insights” were really just extensions of existing knowledge and in one way of thinking they were just in the right place at the right time.

    My discipline is geology and probably all of “my” best ideas were in a way not my ideas at all. In some cases they were a misunderstanding of someone elses’ ideas that actually turned out to be better and more accurate than what the “originator” had concieved – but I thought I was recreating their conception. In other cases, like in the case of Darwin and Wallace, they were just the result of extensions of known principles – in my case usually into what seemed to me to be known territory – but turned out to not be known territory.

    One of the most amazing things I’ve noticed in all my dealings with people in various sciences is how quickly they lose track of the known, relatively simple and incontrovertable fundamentals and wind up floundering around looking for “genius” ideas in a muck of unverified hypotheses, bad assumptions and other just plain bullshit.

    So WTH is “genius”? I’m not really sure, except that it’s a very high complement for which I hold a high bar.

  17. Gravatar of spencer spencer
    6. July 2024 at 06:09

    Your only concerned with N-gDp as it relates to R-gDp (the policy standard).

    Does anyone understand what applying double – entry bookkeeping on a National scale means? It means banks don’t lend deposits. All the accounting entries sum to zero.

  18. Gravatar of ssumner ssumner
    6. July 2024 at 08:05

    Kangaroo, I also don’t know what genius is. But I am confident that whatever it is, I don’t have it.

  19. Gravatar of spencer spencer
    6. July 2024 at 10:19

    Genius is 99% sweat.

    See David Stockman on the US Golden Age in Economics

    What’s notable is the US Golden Age in Capitalism. This was accomplished by 2/3 velocity and 1/3 money. That means drive the banks out of the savings business (which doesn’t reduce the size of the payment’s system).

  20. Gravatar of Carl Carl
    8. July 2024 at 07:27

    I kept finding myself asking what’s the numeraire in this analogy and why doesn’t the fluctuating barrel size affect its relationship to a gallon of oil, but I guess that’s missing the point.

  21. Gravatar of ssumner ssumner
    8. July 2024 at 08:09

    Carl, “I kept finding myself asking what’s the numeraire in this analogy”

    A barrel of oil

  22. Gravatar of Carl Carl
    8. July 2024 at 08:15

    Okay. Does the constancy of the price of a gallon of oil reflect the fact that real supply and demand hasn’t changed then?

  23. Gravatar of Carl Carl
    8. July 2024 at 08:17

    Sorry. I hit enter too soon. It was actually the secondary numeraire that was being used to reflect the constancy of the price of a gallon of oil that I kept wondering about.

  24. Gravatar of ssumner ssumner
    8. July 2024 at 08:36

    Carl, I think I see your confusion. The barrel doesn’t represent a monetary unit in this example, it’s a unit of measurement. Thus I am not literally describing monetary instability in this analogy, I am describing “measuring stick instability”, which has effects that are a bit similar to monetary instability.

    There is no fixed price of oil (per gallon or per barrel) in this analogy, as there would be in a gold standard regime with a fixed price of gold. There are long term monetary contracts for barrels of oil, where the actual terms of the contracts are distorted by unexpected changes in barrel size.

  25. Gravatar of Carl Carl
    8. July 2024 at 09:22

    Thanks Scott. That helps. I was overcomplicating things.

  26. Gravatar of spencer spencer
    9. July 2024 at 07:30

    N-gDp falls too low after August this year.

  27. Gravatar of spencer spencer
    9. July 2024 at 07:37

    Should have said after JULY.

  28. Gravatar of bb bb
    9. July 2024 at 10:35

    Great post. Very helpful.

  29. Gravatar of JP Koning JP Koning
    13. July 2024 at 03:42

    Hi Scott,

    Great blog post. Here’s one thought I had. You introduce us to the very interesting barrel of oil imagery, but when it comes to bringing out a monetary economy you use silver instead of barrels of oil as your numeraire. I thought you were teeing up barrels to be the numeraire, which would have been a lot of fun to work through.

  30. Gravatar of ssumner ssumner
    13. July 2024 at 07:39

    JP, Thanks. I was playing with the famous measuring stick analogy for changes in the value of money. But I didn’t want to confuse people by mixing up changes in physical quantities with changes in the market value of the medium of account, so I decided to switch to a monetary example. The oil example was a sort of “intuition pump”, before moving on to money.

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