Shawn has a masters of public administration, JD, and a BA in political science.
Just because you received a raise, it doesn't mean you have more purchasing power. In this lesson, you'll learn about nominal wages and related concepts.
What Is a Nominal Wage?
A nominal wage is the rate of pay employees are compensated. If you're paid $15.00 per hour, your nominal wage is $15.00 per hour. The most important thing to know about a nominal wage is that it is not adjusted for inflation. Inflation is an increase in the general price level in an economy. Money wages is another term used by some people for nominal wages.
Nominal Wages and Inflation
Since a nominal wage is not adjusted for inflation, it does not accurately reflect the purchasing power your wage provides you. In the simplest terms, prices usually rise, and a dollar today is worth more than the same dollar tomorrow. The same is true of nominal wages.
If the wage rate doesn't keep up with inflation, your wages can't buy as much. In fact, even if you receive a raise in your wage, if the percentage increase in your wage is lower than the percentage of inflation, then you still have less earning power than you did the year before you got the raise. In order to see the effect of inflation on wages, you need to determine the real wage, which is the wage rate adjusted for inflation.
Reaction to Declining Nominal Wages
Wages are like any other good and are subject to the law of supply and demand. If the demand for labor decreases and the supply stays the same or increases, the nominal wage offered by employers in exchange for labor decreases. On the other hand, if the demand for labor increases, but supply stays the same or decreases, then the wage demanded by potential employees will increase. Nominal wages stabilize where the supply of labor equals the demand for the labor.
Economists vary on how they perceive people's reaction to a decrease in nominal wages. Economists of the classical school of thought assume that individuals are completely rational and will respond to changes in the real value of wages rather than the nominal value. Under this theory, a pay decrease will not necessarily be considered a bad thing so long as your purchasing power stays the same.
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On the other hand, the founder of the Keynesian school of thought, John Maynard Keynes, theorized that workers will stipulate to a nominal wage rather than a real wage, within limits. Keynes makes some common sense, as we don't see massive numbers of employees quitting their jobs because their wages do not keep up with rising prices.
Some take a view of near-rationality where people use the nominal wage as a rule of thumb and don't worry much about the difference between their real wage and their nominal wage if inflation is relatively low. In other words, people will accept a haircut in real wages, but may not accept getting shaved bald.
Let's review. A nominal wage, also called a money wage, is the money you're paid by an employer for your labor. A nominal wage is not adjusted for inflation. On the other hand, a real wage is a wage adjusted for inflation. If your nominal wage increases slower than the rate of inflation, then your purchasing power will decline. Classical economists believe that workers react rationally and will respond to changes in the real value of wages rather than the nominal value. Keynesian economists, on the other hand, believe that workers often accept nominal wages within limits. Some economists believe that people will pretty much not worry about the difference between real wages and nominal wages as long as the rate of inflation doesn't cut much into their purchasing power.
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