Monthly Archives: April 2015

A New Economic Theory of Price Determination

  • The view of The Money Enigma is that current microeconomic models of price determination provide a limited and very one-sided view of the price determination process. In this week’s post, we shall explore the theory that every price is a function of two sets of supply and demand. More specifically, the price of one good (“the primary good”) in terms of another good (“the measurement good”), is determined by both supply and demand for the primary good and supply and demand for the measurement good.
  • The traditional microeconomic view is that price is determined by supply and demand for one of the goods being exchanged (the “primary good”). For example, the traditional view is that the price of apples is determined by supply and demand for apples. However, in every transaction, there are two goods that are exchanged.
  • For example, in a barter economy, we might exchange two bananas for one apple. So, does the price of this trade (the ratio of bananas for apples) depend upon supply and demand for apples or supply and demand for bananas? The answer is both.
  • We can apply this concept to the determination of “money prices”. In a money-based transaction, we exchange one good (the primary good) for money (the measurement good). The price of the primary good, in money terms, is a function of both supply and demand for the primary good and supply and demand for money (the measurement good).
  • The notion that “every price is a function of two sets of supply and demand” provides us with a universal theory of price determination: it is a theory of price determination that can be applied to the determination of any price: good/good prices (barter prices), good/money prices (“money prices”) or money/money prices (foreign exchange rates).
  • In order to illustrate every price as a function of two sets of supply and demand, we need to understand the measurement of “market value”. In last week’s post, we examined what a “price” is. It was argued that every price is a relative measurement of market value: the market value of one good (the “primary good”) in terms of the market value of another good (the “measurement good”).
  • Furthermore, we discussed the notion that market value can be measured in the absolute. In order to measure a property in the absolute, you need a “standard unit” of measurement. It was proposed that economics should adopt a standard unit for the measurement of market value called “units of economic value”.
  • We can use this standard unit to plot how supply and/or demand for a good might react to changes in the absolute market value of that good (the market value of the good as measured in terms of our “standard unit”). Rather than plotting supply and demand with price (a relative measure of market value) on the y-axis, we can plot supply and demand using our “standard unit” on the y-axis (an absolute measure of market value).
  • Importantly, this allows us to plot supply and demand for both goods that are being exchanged independently. We can then examine whether a change in the price of the primary good, in terms of the measurement good, is due to a change in supply and demand for the primary good or supply and demand for the measurement good.

Price Determination TheoryThe view of The Money Enigma is that every price is a function of two sets of supply and demand.

What this means, in simple terms, is that the price of one good, in terms of another good, depends upon supply and demand for both goods.

Price Determined by Two Sets Supply and DemandFurthermore, this principle holds true in a money-based economy. The price of a good, in terms of money, depends upon both supply and demand for the good and supply and demand for money (the monetary base). Notably, supply and demand for money (the monetary base) determines the market value of money, not the interest rate.

There are two ways to explain this theory. First, there is a simple, intuitively appealing and fairly non-technical way to think about the issue. Second, there is a far more technical path that requires an understanding of the issues discussed in last week’s post “The Measurement of Market Value: Absolute, Relative and Real”. Let’s begin with a simple overview of the theory and think about how prices are determined in a barter economy.

Price Determination in a Barter Economy: A Simple Overview

Price determination in a barter economy may seem like a strange topic to discuss in a world where nearly all transactions are conducted with money. However, analysing the process of price determination in a barter economy allows us to get back to basics and really think about the issues involved.

If we can understand how prices are determined in a barter economy, then this provides us with a basic model that we should be able to extend into a money-based economy. Furthermore, a comprehensive theory of price determination should be able to explain not only the determination of prices in a money-based economy, but also the determination of prices in a barter economy with no money and no accepted medium of exchange.

Let’s imagine a barter economy with no accepted medium of exchange (no good is used as “money”) and think about how prices are determined in that economy. For example, let’s try and answer this question: “how is the price of apples determined in a barter economy?”

Already, we have a problem. What do we mean when we say “the price of apples” in the context of a barter economy?

In a money-based economy, we would normally assume that the question refers to the price of apples in money terms. However, in our barter economy, there is no money and no good that is used as money. So, exactly what is “the price of apples” in the context of a barter economy?

There are many different ways to express the price of apples in a barter economy. We could express the price of apples in terms of bananas, or in terms of rice, or in terms of any other good that is widely traded in that economy.

The key point here is that the price of apples must be expressed in terms of some other good. Why? Every price, including the “price of apples”, is a ratio of two quantities exchanged: a certain quantity of one good for a certain quantity of another.

Let’s choose bananas as our second measurement good, the good that we use to measure the price of apples and let’s ask the question again: “how is the price of apples, in banana terms, determined in a barter economy”?

Now we have a meaningful question to answer. But before we do, let’s restate the question. As discussed, every price is a merely a ratio of two quantities exchanged. So let’s rephrase the question this way: “how is the ratio of exchange between bananas and apples determined in a barter economy?”

Does the ratio of exchange, “bananas for apples”, depend upon supply and demand for apples, or does it depend upon supply and demand for bananas? The answer is both.

For argument’s sake, let’s assume that the current ratio of exchange in our barter economy is two bananas for one apple (the price of apples, in banana terms, is two bananas). What are the factors that might influence this ratio of exchange?

What would be the impact of a sharp reduction in supply of apples upon the ratio of exchange? For example, if the apple crop failed and apples were in short supply, then, all else remaining equal, what would happen to the ratio of exchange “bananas for apples”? Clearly, the price of apples, in banana terms would rise: you would have to offer more than two bananas in order to get your hands on an apple, apples now being in short supply.

This example sits well with mainstream theory. A reduction in the supply of apples will increase the price of apples.

Now, let’s try a different scenario. Once again, let’s assume the ratio of exchange is two bananas for one apple. What happens if, all else remaining equal, there is a sharp reduction in the supply of bananas?

Let’s step back and think about this. Imagine a new parasite damages most of the banana tress and the supply of bananas is cut dramatically. All else remaining equal, do you think it would still be possible to swap one apple for two bananas? No. There is a shortage of bananas and bananas are now more valuable. Therefore, you would expect that one apple might only be able to obtain one banana, rather than the previous two bananas. Perhaps you might even need to offer two apples to buy one banana.

The point is that our ratio of exchange, bananas for apples, depends upon both supply and demand for apples and supply and demand for bananas. The problem for mainstream economics is that our example implies that the price of apples (the ratio of bananas exchanged for apples) depends upon supply and demand for bananas!

So, how do we resolve this seemingly awkward situation?

At a high level, the answer is simple. All we need to do is to recognize the general principle that the price of one good, the “primary good”, in terms of another good, the “measurement good”, depends upon both supply and demand for the primary good and supply and demand for the measurement good.

In the case of our example, the price of apples (the “primary good”), in terms of bananas (the “measurement good”), depends upon both supply and demand for apples and supply and demand for bananas.

The harder issue that we need to address is how do we illustrate this? How do we show the price of apples, in banana terms, as a function of two sets of supply and demand?

This brings us to the more technical part of our discussion. In order to understand how every price can be illustrated as a function of two sets of supply and demand we need a better understanding of what a “price” is and how the property of “market value” can be measured.

Every Price is a Function of Two Sets of Supply and Demand

In order to understand how every price is a function of two sets of supply and demand, we need to step back and think about the concept of “price”.

So far, we have discussed the widely accepted notion that every price is a ratio of two quantities of exchanged: a certain quantity of a measurement good for a certain quantity of a primary good.

This definition is fine, but it doesn’t tell us much about the process of price determination. Rather, we need to think about the concept of “price” in more fundamental terms. More specifically, what does the price of a good, in terms of another good, indicate to us about the relative economic relationship that exists between the two goods?

Let’s return to our apples and bananas example for one moment. If the ratio of exchange in our barter economy is two bananas for one apple, then what does that imply about the value of apples relative to the market value of bananas? Clearly, it suggests that one apple is worth twice as much as one banana.

In slightly more technical terms, we can say that the market value of one apple is twice the market value of one banana. The apple possesses the property of “market value”. Similarly, the banana possesses the property of “market value”. The price of apples, in banana terms, reflects the relative market value of the two goods being exchanged (the market value of apples relative to the market value of bananas).

Therefore, we can say that “price” is a relative measurement of the property of “market value”. All economic goods (including money) possess the property of market value. A “price” is one method of measuring the market value of a good: it measures the market value of a good in terms of the market value of another good. For example, if the price of an apple, in banana terms, is two bananas, then this implies that an apple has twice the market value of a banana.

The observation that “every price is a relative measure of market value” is interesting because it suggests that there is an alternative way to measure the property of “market value”: the alternative method is measuring market value in the absolute.

Before we think about measuring market value in the absolute, let’s think about what is required to measure any physical property in the “absolute”. We discussed this topic at great length in last week’s post “The Measurement of Market Value: Absolute, Relative and Real”. While the topic may seem a little abstract, it is a critical concept to this theory of price determination and I strongly encourage you to read it.

By convention, in order for a measurement to be considered an absolute measurement, it must be made using a “standard unit” of measurement. For example, in order to measure the height of a tree in an absolute sense, we need a standard unit of measurement for height, such as inches.

Standard units of measurement have two critical properties. First, they must possess the property that they are used to measure. Second, they must be invariable in that property.

There is a third property common to most standard units: they tend to be theoretical in nature. For example, there is no such thing in nature as “one inch”. We made it up. The reason most standard units are artificial/theoretical is because almost nothing in nature is invariable.

This is true of the market value of goods. No good possesses the quality of invariable market value. Therefore, no good can act as a “standard unit” for the measure of market value. This is also true of money (currencies). No currency possesses the property of invariable market value.

So, how do we measure market value in the absolute? We need to create a standard unit for the measure of market value. Since no standard unit for the measurement of market value exists in nature, we need to make one up. In last week’s post, I proposed that we introduce a standard unit called a “unit of economic value”. “Units of economic value” are invariable measures of the property of market value, just as feet and inches are invariable measures of the property of length.

Adopting this standard unit for the measurement of market value is important because it allows us to demonstrate two critical points.

First, it allows us to illustrate how the price of a primary good, in terms of a measurement good, is a relative expression of the market value of both the primary good and the measurement good.

Consider our earlier example, the price of apples in banana terms. Let’s assume that we measure the market value of apples using our new standard unit. We can now measure the market value of apples in the absolute and denote this as V(A). Furthermore, we can separately measure the market value of bananas using our new standard unit and denote the absolute market value of bananas as V(B).

Price as Ratio of Two Market ValuesThe price of apples, in banana terms, is a relative measurement of the market value of apples V(A) and in terms of the market value of bananas V(B). For example, if the market value of an apple is twice that of a banana, then the price of apples, in banana terms, is two bananas. Mathematically, the ratio of quantities exchange, the quantity of bananas Q(B) for a quantity of apples Q(A), is simply the reciprocal of the ratio of the two absolute market values.

The slide above implies that the price of apples, in banana terms, simply depends upon the market value of apples relative to the market value of bananas. All else remaining equal, if the market value of apples V(A) rises, then the price of apples will rise. Conversely, if the market value of bananas V(B) rises, then the price of apples, in banana terms, will fall.

We can extend this to a money-based economy. In a money-based economy, the market value of money is the denominator of every “money price”. All else equal, if the market value of money rises, then prices will fall. If the market value of money falls, then, all else equal, prices will rise.

The second important use for our standard unit for the measurement of market value is that it allows us to demonstrate how every price can be illustrated as a function of two sets of supply and demand.

As discussed, the price of apples, in banana terms, depends upon both the market value of apples V(A) and the market value of bananas V(B). How is the market value of a good determined? Supply and demand!

Price Determination Barter EconomyThe market value of apples V(A) is determined by supply and demand for apples. The market value of bananas V(B) is determined by supply and demand for bananas. The price of apples, in banana terms, is a relative expression or a ratio of these two market values. Therefore, the price of apples, in banana terms, is determined by two sets of supply and demand.

This illustration of the price determination process is  useful because it allows us to isolate and analyze how changes in either market (the market for apples or the market for bananas) may impact the price of apples as measured in banana terms. For example, an increase in supply of bananas will lower the market value of bananas V(B). If nothing changes in the market for apples (the market value of apples V(A) is constant), then the price of apples, in banana terms, will rise as a result of an increase in supply of bananas.

Price Determined by Two Sets Supply and DemandWe can extend this paradigm to the determination of money prices by simply replacing one measurement good (bananas) with another measurement good (money). The price of apples, in money terms, is determined by both supply and demand for apples and supply and demand for money.

It should be noted that this concept sits in stark contrast to traditional Keynesian theory. Keynes’ liquidity preference theory suggests that supply and demand for money determines the interest rate. The view of The Money Enigma is that this is wrong. In order for prices to be expressed in money terms, money must possess the property of market value. Supply and demand for money determines the market value of money. In turn, the market value of money is the denominator of every “money price” in the economy.

Before we finish this week’s post, I want to make one final point. This theory of price determination can be neatly reconciled with the traditional illustration of supply and demand taught in economics textbooks.

The traditional view is that the price of a good is determined by supply and demand for that good. Economists illustrate this by using “price” on the y-axis. This view of the price determination process is fine as long as it is recognized by the user that this traditional illustration of the price determination process implicitly assumes that the market value of the measurement good is constant.

For example, in our barter economy, if we assume that the market value of bananas is constant, then when we plot supply and demand for apples we don’t need to use our theoretical standard unit for the measurement of market value on the y-axis. Rather than using a theoretical invariable measure of market value (units of economic value) we can simply use an assumed invariable measure of market value (the market value of bananas).

While it may not be explicitly acknowledged, most textbook illustrations of price determination simply assume that the market value of the measurement good (most commonly “money”) is constant. This is perfectly fine if the assumption is acknowledged. However, this traditional view of supply and demand provides most students with a very one-sided view of the price determination process.

The view of The Money Enigma is that every price is a function of two sets of supply and demand. The current mainstream view that price is a function of one set of supply and demand is a primary source of many misconceptions in economics, most notably, the poorly conceived notion that supply and demand for money determines the interest rate.

If you would like to learn more about these theories then please visit the Price Determination section of The Money Enigma.

Author: Gervaise Heddle, heddle@bletchleyeconomics.com

The Measurement of Market Value: Absolute, Relative and Real

  • In any scientific pursuit, it is critical to understand the different approaches that can be used to measure the physical properties that are being studied. At the most basic level, every scientist must be able to distinguish between an “absolute” measurement and a “relative” measurement.
  • Relative measurement is measuring something compared to other things, or estimating things proportionally to each other. For example, “the tree is twice as tall as the girl”.
  • Absolute measurement is measuring something compared to a “standard unit”. For example, we can use feet and inches to measure the height of the tree, “the tree is six feet high”.
  • What makes something a “standard unit” of measurement? A “standard unit” of measurement must possess two characteristics. First, the standard unit must possess the property being measured. Second, the standard unit must be invariable in that property (the length of one “inch” never changes; it is and must be invariable in order for it to be useful as a standard unit of measurement).
  • In the science of economics, one of the most important properties that economists are concerned with is the property of “market value”. Surprisingly, economics does not have a “standard unit” for the measurement of market value and, consequently, economics does not measure market value in the absolute.
  • “Price”, the most commonly used measure of market value, is a relative measure of market value. The price of one good, in terms of another good, is a relative measurement of market value, namely, the market value of one good (the “primary good”) in terms of the market value of another (the “measurement good”).
  • It is proposed that economics needs to introduce a standard unit for the measurement of market value. The adoption of this standard unit has many advantages. First, it can be used to illustrate how price is a relative expression of the market value of each of the two goods involved in an exchange. Second, it can be used to illustrate how every price is a function of not one, but two sets of supply and demand.
  • Furthermore, we can use the standard unit of market value to illustrate that supply and demand for money does not determine the interest rate. Rather, supply and demand for money determines the market value of money, the denominator of every “money price”.
  • In the last section, we will discuss the concept of “real prices”. Many commentators seem to believe that the “real price” of a good is somehow an absolute measurement of market value. It is not. It will be argued that a real price is a relative measure of market value. More specifically, the real price of a good is merely the market value of a good in terms of the market value of the basket of goods. The market value of the basket of goods is not invariable. Therefore, a real price is not an absolute measurement of market value.

Absolute versus Relative Measurement: the General Principle

The act of measurement is, by definition, an act of comparison. In this sense, all measurements are “relative”. For example, consider the height of the tree. We can measure the height of the tree in terms of the girl standing next to the tree (the tree is twice as tall as the girl) or in terms of feet and inches (the tree is six feet tall). Either way, we are comparing one thing that possesses the property of height/length (the tree) with another thing that possesses the property of height/length.

But if all measurement is an act of comparison (for example, comparing the tree to feet and inches), then what does it mean to say that a measurement is “absolute”?

A measurement is considered to be “absolute” if we measure something compared to a “standard unit” of measurement. In our example above, a “girl” is not a standard unit of measurement for the property of height/length. However, “feet” and “inches” are recognized as a standard unit of measurement for height/length. Therefore, the height of the tree in feet/inches is an absolute measurement of the height of the tree.

What makes something a “standard unit” of measurement?

In order for something to act as a standard unit of measurement for a given property, there are two key characteristics that thing must possess. First, it must possess that property. This may sound odd, but think about it. You couldn’t use an “inch” to measure length if an “inch” had no length.

Second, for something to be used as a standard unit of measurement, it must be invariable in that property. Measuring things in terms of “inches” wouldn’t be of much value to us if the length of one inch was constantly changing.

These are the two key characteristics of a standard unit of measurement, but there is a third characteristic that most standard units possess.: most “standard units” of measurement are theoretical.

In our example above, the girl has a certain physical height that exists in nature. However, the length of one “inch” is not something that exists in nature. We made it up. We decided, on a fairly arbitrary basis, that the length of one inch is “about that much”.

This is true of most standard units of measure: one hour, one mile, one kilogram – they are all theoretical measures of a particular property that we made up to help us measure various physical properties.

Why are most standard units of measurement theoretical? The reason we use theoretical entities as standard units of measure is because nearly everything in nature is variable. By definition, we can’t use objects that are variable in a property as “standard units” of measure of that property.

In summary, the key difference between an “absolute” and a “relative” measurement is the unit of measure being used. In the case of an absolute measurement, we use a “standard unit” of measure. Most standard units are theoretical units of measure and, importantly, they must be invariable in the property that they are measuring.

In contrast, a relative measurement is merely a comparison of one object (the primary object) with another (the measurement object): it does not require that the second object (the measurement object) is invariable in the property being measured.

In the next section, we will examine how “price” is a relative measurement of the property of “market value”. Furthermore, we will discuss the difference between “absolute” and “relative” market value and why the science of economics should introduce of a “standard unit” of measurement for the property of market value.

The Measurement of “Market Value”

By far the most popular way to measure the market value of a good is the “price” of a good. More specifically, the price of a good, as measured in currency terms, is what most people think of as the “market value” of that good.

However, “price” and “market value” are not the same thing.

“Market value” is a property of a good, a property determined by the interaction of economic agents. “Market value” is a property of a good, just as “length” is a property of a physical object.

“Price” is a method of measuring market value. More specifically, every price is a relative measurement: it is a measure of the market value of one good (the primary good) in terms of the market value of another good (the measurement good).

In our modern economy, the measurement good we normally use is money (prices are expressed in money terms). The problem with this, from a theoretical perspective, is that money is not a “standard unit” in the scientific sense. Why? Money is not a standard unit because the market value of money is not invariable. Rather, the market value of money, particularly fiat currency, is highly variable, especially over long periods of time.

Therefore, a “price” is a relative measure of market value, not an “absolute” measure of market value. This is an important distinction, for reasons we shall discuss shortly. But before we do, let’s take a moment to consider what it means to say that “every price is a relative measurement of market value”.

Let’s imagine that we are sitting at a table and I put on the table a one-dollar note and a banana. Next, I tell you that the market value of the banana is three times that of the one-dollar note. In other words, one banana is three times more valuable than one one-dollar note.

What is the price of the banana?

It’s not a trick question: the answer is three dollars. But why is the price of the banana “three dollars”?

Let’s think about it in terms of our earlier discussion. Both of the items on the table possess the property of “market value”. The banana has market value. The one-dollar bill has market value. We know this must be the case. Why? If one of the goods does not possess the property of market value, then we can’t compare them: we can’t say that “one banana is three times more valuable than one one-dollar bill” unless both the banana and the one-dollar bill have value.

In this example, the banana is three times more valuable than the one-dollar bill. If I wanted to buy the banana from you, I would have to offer you three dollars in exchange for the banana. This ratio of quantities exchanged (three dollars for one banana) is the price of the trade and it is determined by the relative market value of the two goods being exchanged (the banana is three times more valuable than the dollar).

The price of the banana, in dollar terms, is a relative measurement of market value: the market value of bananas (the primary good) as measured in terms of the market value of money (the secondary good).

The simple notion that “price is a relative measurement of market value” implies that the price of a good, in money terms, can rise either because (1) the market value of the good rises, or (2) the market value of money falls.

But, how do we know if a price rise is caused by the first factor or the second factor? In order to assess this, we need a standard unit of measurement for market value. In other words, we need a theoretical and invariable unit of measure that can be used to measure whether the price has risen because (1) the market value of the good has risen, or (2) the market value of money has fallen.

Unfortunately, there is no “standard unit” for the measurement of market value in economics. Perhaps one reason for this is because there is no good that possesses the property of invariable market value. Human economic relationships are constantly changing and our resources are constantly changing, therefore there is no good, nor unit money, nor unit of labor that possesses the property of invariable market value.

But, that doesn’t mean we can’t create a theoretical standard unit of market value that we can use to measure the market value of any good or currency in the absolute. Just as we have created theoretical standard units of measure for length, weight and speed, so we can create a theoretical standard unit of measure for the property of market value.

The Enigma Series proposes the introduction of a standard unit for the measurement of market value. For lack of better name, this standard unit of market value is called a “unit of economic value” or “EV” for short.

You might ask: “how much is a unit of economic value”? Frankly, it doesn’t matter. We are not going to run around the farmers’ market measuring the market value of goods in EV terms. Rather, our standard unit of market value is a theoretical tool, a tool that can help us think about challenging theoretical problems in economics such as price determination and inflation.

Once we have a standard unit for the measurement of market, we can do a lot of interesting things with it. For example, we can clearly illustrate how “price” is a relative expression, or a “ratio”, of the market value of two goods.

Imagine that we have two goods, good A and good B. Now, imagine that we can measure the market value of good A in terms of our standard unit (units of economic value) and we denote this “absolute” market value of good A as “V(A)”. Now, imagine that we do the same thing with good B and denote the absolute market value of good B as “V(B)”.

The price of good A, in terms of good B, can now be expressed in two ways. We can express the price in the traditional way, as a ratio of the two quantities exchanged, or we can express the price as a ratio of the absolute market value of the two goods.

Price as Ratio of Two Market Values

The slide above implies that the price of good A, in good B terms, can rise either because (1) the market value of good, as measured in the absolute, rises, or (2) the market value of good B, as measured in the absolute, falls. In terms of our earlier example, the price of a banana (good A), in money terms (good B), can rise either because the market value of bananas V(A) rises or because the market value of money V(B) falls.

Where this idea gets really interesting is that it allows us to illustrate that every price is a function of two sets of supply and demand. The slide below illustrates how the price of good A, in good B terms, is determined by both supply and demand for good A and supply and demand for good B.

Price Determination Theory

The key to this illustration is our “standard unit” of measurement for market value. We can use this standard unit for measurement on the y-axis to plot supply and demand for both goods independently.

The view of The Enigma Series is that every price is a function of two sets of supply and demand. In simple terms, if price is a relative measurement of the market value of two goods (the market value of a primary good relative to the market value of the measurement good) and if the market value of a good is determined by supply and demand, then every price must be determined by two sets of supply and demand.

We will explore this theory of microeconomic price determination in greater detail next week. For now, the key point that I want to make is that the adoption of a standard unit for the measurement of market value could open up a lot of very interesting theoretical pathways for the science of economics.

“Real” is not “Absolute”

There is a view among some commentators that the real price of a good is somehow an absolute measure of the market value of that good.

It isn’t.

The “real price” of a good is itself a price and, by definition, a relative measure of market value, not an absolute measure of market value.

In order to understand this concept, we can break it down into two simple parts. First, what is a “real price”? Second, what is required for something to be an “absolute” measurement?

The “real price” of a good measures how the price of a good changes in terms of the price of the basket of goods. The price of the basket of goods is also known as the “price level”.

For example, if the price of a banana triples, while over the same period the price level doubles, then we can say that the “real price” of the banana has increased by 50%.

The concept of “real prices” is a very useful concept. But, a real price is not an absolute measure of the market value of a good.

As discussed, in order for a measurement to be considered an “absolute” measurement, we need to use a “standard unit” of measure. Something can only act as a “standard unit” of measure if it is invariable in the property that it is being used to measure.

The price level is not invariable. The price of the basket of goods changes significantly over time.

Moreover, and perhaps more importantly, the basket of goods is not invariable in the property of market value. As discussed earlier, the market value of goods is constantly changing. Moreover, an average of the market value of a basket of goods is also constantly changing. Therefore, the basket of goods is not invariable in the property of market value and can not be used as a standard unit for the measurement of the property of market value.

Closing the loop, a “real price” is itself a “price”. The “real price” of bananas is simply the price of bananas in terms of the basket of goods. If the market value of the basket of goods is variable, which it is, then the “real price” is merely another form of relative measurement.

The Case for Unwinding QE

  • Ben Bernanke, former Chairman of the Federal Reserve, says in his new book that it took “moral courage” to embark on the path of quantitative easing. I suppose that history will be the judge of that statement. What is clear, seven years later, is that the Fed’s failure to reverse QE does not represent an act of courage, but rather a lack of courage.
  • Quantitative easing (“QE”) is, without doubt, the most controversial of all monetary policy programs conducted by the Federal Reserve in its one hundred year history. This week we will consider the benefits and the costs associated with reversing such an unprecedented and aggressive program of monetary base expansion.
  • While the near-term costs of reducing the monetary base may seem to outweigh the benefits, there is a terrible risk associated with the path of inaction. If the Federal Reserve fails to act, then the Fed risks losing not only its credibility, but any significant control over economic outcomes.
  • In many ways, the decision by the Fed to reduce the monetary base is similar to the decision that many of us might face when we think about returning to the gym after a period of long absence. It may be tough to get back on the treadmill after weeks of inactivity, but most of us understand that the benefits are worth it. Moreover, the long-term risks of not any taking action are, quite frankly, unacceptable.
  • Reversing quantitative easing is a good step for the long-term health of the economy. Capitalism, just like the human body, works best when it is constantly being tested. When the capital markets are working efficiently, good ideas thrive, while bad ideas are quickly discarded. By removing the trillions of excess capital that have flooded the global markets, both debt and equity markets can once again begin to send the right price signals to investors and entrepreneurs.
  • However, getting back into a regular exercise routine is tough. Similarly, removing a couple of trillion dollars from global financial markets is not going to be easy. There will be inevitable negative consequences in both the financial economy (a fall in the value of most financial assets) and the real economy (recession and higher unemployment), consequences that will make it politically difficult for the Fed to persist.
  • Nevertheless, while reversing quantitative easing will be no walk in the park for the global economy, the alternative is much worse. If the Fed fails to reduce the monetary base, then high levels of inflation will return. In a world overburdened with both private and public sector debt, a return of high inflation would have terrible consequences on the ability of the West to maintain current levels of leverage and, consequently, the global economy.

What is Courage?

Courage is the mental or moral strength to act in the face of fear and difficulty. Last week, Ben Bernanke claimed that it took “moral courage” to embark upon the path of quantitative easing. While it may have taken a certain intellectual “conviction” to commence quantitative easing, it is not clear that it took great “courage” to embark upon a program that the markets, and the public more generally, welcomed with open arms.

In contrast, reversing quantitative easing and reducing the bloated balance sheet of the Federal Reserve will require an act of great courage.

Let’s be clear on this point. In late 2008/early 2009, when the financial markets were in turmoil, the public-at-large, Wall Street and most politicians demanded that the Fed take dramatic action. With the Fed funds rate sitting already sitting at an extraordinarily low level (the fed funds rate was 1% at the time the depths of the crisis hit), the Fed had backed itself into a corner. It had little choice but to attempt something new.

Consequently, it didn’t take an act of “courage” to do something new and drastic in early 2009. However, this isn’t to say that it wasn’t the right thing to do: the first round of quantitative easing (QE1) represented a novel approach to crisis management and, at least in my personal opinion, it was an appropriate response in the circumstances at that time. Arguably, the most important mandate of the Fed, a role that is far more important than aggregate demand management, is “crisis control”. In early 2009, the Bernanke team did what had to be done. But it could hardly be described as an act of great courage.

Courage, in the political sense, is having the intellectual and moral strength to do the right thing in the face of tremendous opposition. It didn’t take great political courage to embark upon the path of QE, but it will take great political courage to substantially reverse QE.

In order to understand why there will be great opposition to any reversal of QE, we need to think about the impact that QE has had on both the markets and the economy. The best way to do this is to put the trillions of dollars created by QE into context.

Benefits and Costs of Unwinding QE

A few months ago I wrote a post titled “2015: A Happy New Year for Markets?” which attempted to highlight the incredible scale of the Fed’s quantitative easing program. The $4 trillion that has been created and “invested” in the global markets by the Federal Reserve over the last six-year period is an astonishing sum.

It is hard for most people to put this amount of money into context, but here is one example. If we assume that every car in America was bought with cash (no loans, no leases), then the American public would have to give up all new purchases of cars for six years in order to save and invest the same amount of money that the Federal Reserve has created and invested in the markets. You can see the math behind this in the original post mentioned above.

With this example in mind, it isn’t hard to see how the Fed’s actions have created a massive distortion in capital markets. In the normal course of business, the $4 trillion created by the Fed and invested in fixed income securities would need to be saved by American consumers, a process that would have created a severe economic recession. As the Federal Reserve bought government bonds (and limited amounts of other fixed income securities), this lowered the expected rate of return across all investment classes (government bonds, corporate bonds, listed equities, private equity, etc.), pushing yields to record lows and equities to record highs.

As you might imagine, just an incoming tide will lift all boats, so an outgoing tide will lower all boats. The problem is that there are a lot of people sitting in boats that are going to hit the rocks as the tide goes out. And this brings us to our first key point: it is going to be very difficult politically for the Federal Reserve to reverse quantitative easing.

By lowering expected rates of return across all assets, the Federal Reserve has induced a boom in global financial markets and a recovery, albeit sluggish, in the global economy, particularly in those sectors leveraged to cheap money (the shale oil industry is a great example of this).

However, not only does this process work in reverse, but it will probably follow a more volatile path. As the Federal Reserve sells the bonds on its balance sheet, someone has to buy them. At the margin, this means that someone has to sell corporate debt and equities to buy government bonds. If lots of people try to do this at the same time, then it is very easy for prices of these securities to adjust rapidly in order for equilibrium to be restored.

Aside from the very real potential of a market crash, reversing quantitative easing will have a short-term negative effect on the real economy (jobs etc.). As the cost of capital rises across the economy, new business projects will stall and many businesses that have survived on cheap debt and equity funding (shale oil, early-stage biotech, etc.) will suddenly find themselves with few backers.

Clearly, this doesn’t sound like a great scenario. So why should the Fed reverse quantitative easing?

First, let’s consider the benefits of reversing QE and then we can consider the long-term costs associated with a failure to reverse.

The key benefit from reversing QE is simple, but surprisingly difficult for most people to grasp. The long-term health of any society depends upon the efficient allocation of its scarce resources. Quantitative easing distorts the markets and removing this distortion is a good thing for our society.

While this point should be obvious to an educated person, there are many in the political classes who don’t seem to understand this important principle.

In a small tribal economy, the survival of everyone in that tribe depends upon the efficient use of the scarce resources. If people waste time gathering food that won’t store or making tools that the community doesn’t need, then this will imperil the ability of that small community to get through the tough times.

While the dynamics of a modern industrialized economy are much more complex, the principle is the same. Our society has limited resources and for our society to grow and prosper it must allocate all these resources to the right economic activities. This process begins in the capital markets: the markets for equity and debt securities need to send the right signals in order for everyone in our society to make sensible decisions about consumption, saving and investment.

A reversal of QE will remove much of the “froth” that currently exists in global capital markets, thereby enabling these markets to do their job more effectively.

This may sound like a bad deal: an economic recession and a fall in asset values all for the sake of “efficient capital markets”. Why should we as a society choose this path short-term pain?

The answer is simple: long-term gain.

We can use the analogy of returning to a regular exercise routing after a long absence. For most of us, running on the treadmill isn’t a lot of fun. “Rewarding” perhaps, but not “fun”. So why do we do it? The answer is that we trade off short-term pain for long-term gain. By physically stressing our bodies today, we prepare them for the challenges they face in the years ahead.

We can say the same for our society. By getting back on the treadmill of free market capitalism (and let’s face it, it is a treadmill and the experience is often not that “fun”), we prepare ourselves for the challenges that our society will face in the future. If we start making the right decisions today, then we don’t have reverse poor decisions in the future. Furthermore, the longer we put off making the right choices, the harder it will be when we have to.

Avoiding the Unthinkable

So far we have considered the benefits and costs of unwinding QE. But what happens if the Fed chooses not to unwind QE? Is there a happy ending?

The short answer is “no”.

But before we get into a discussion of economic theory, let’s return to our simple analogy and think about what happens when we keep avoiding regular exercise and a healthy lifestyle.

In the short-term, it doesn’t make much difference whether you get back the gym or not. You may start to notice that you are a little out of breath walking up the stairs at work or maybe the belt needs to be let out one notch.

However, in the long-term, it makes a very noticeable difference. More importantly, the “long-term” can suddenly and very painfully catch up with us (diabetes, heart attack, etc.)

Failure to return to a regular exercise routine probably won’t lead to disaster overnight, but it dramatically increases the risk of a whole series of outcomes that are “unthinkable”.

Similarly, central bank intervention will not lead to disaster overnight: thoughtful and temporary intervention by the central bank in capital markets will often make sense, particularly in a time of crisis. But if markets become addicted to central bank intervention, then it dramatically increases the risk of a whole series of “unthinkable” economic outcomes.

The best of these bad outcomes is a return of high inflation.

Many economies can sustain relatively high rates of inflation (5%-15% per annum) without a dramatic collapse in real economic activity or investment. In some ways, this type of inflation is the type 2 diabetes of economic life: you can live with it, but it isn’t great.

However, inflation can create very poor economic outcomes if coupled with other pre-existing economic conditions (just as diabetes can create very poor health outcomes if coupled with other pre-existing medical conditions). Most notably, economies that have become increasingly addicted to very low nominal interest rates and credit expansion are very vulnerable to even a modest increase in the rate of inflation.

So, why will inflation return if the Fed fails to reverse quantitative easing?

There are two ways to answer this question: there is a simple answer and a more complex answer.

The simple answer is that, in the long run, the quantity theory of money works. Over long periods of time, an increase in the monetary base that is in excess of an increase in real output, will lead to a corresponding increase in the price level.

This shouldn’t be a controversial point. The long-term empirical relationship between the “base money/real output” ratio and the price level has been extensively documented and discussed. While economists have developed many different theories regarding inflation (cost push, demand pull, output gap, inflation expectations, etc.), the only theory that has clear empirical support for explaining the long-term evolution of prices is the quantity theory of money.

Recently, many commentators seem to have become comfortable either ignoring quantity theory or dismissing it outright. It is very easy to fall into this trap because quantity theory does not hold in the short-term. For example, in the United States, the massive increase in the monetary base has not resulted in any inflation (at least not yet!).

Unfortunately, most commentators don’t understand the role of expectations in determining the value of money and, consequently, the price level.

The view of The Money Enigma is that the value money depends primarily upon expectations of the long-term (20-30 year) path of the “real output/base money” ratio.

Despite the massive increase in the monetary base, the markets still believe that QE is a temporary phenomenon. In other words, the markets expect that the Federal Reserve will reduce the monetary base over the next few years. Moreover, markets remain optimistic about long-term economic growth in the US, despite the threat of this reduction in the monetary base.

However, if the markets begin to doubt the Fed’s commitment to reducing the monetary base, or if the markets become more pessimistic about long-term growth in the US, then the value of the US Dollar could decline sharply and the price level could rise rapidly.

Why does the value of money depend upon distant future expectations regarding the size of the monetary base relative to real output? Those readers who are interested in the answer to this question should read “Money as the Equity of Society”.

In short, the view of The Money Enigma is that money is a proportional claim on the future output of society. Just as common stock is a proportional claim on the future cash flows of a business, so money is a special-form equity instrument that represents a proportional claim on the future cash flows of society.

We can use this concept to create a valuation model for money. The absolute market value of money (the market value of money as measured in terms of a standard unit for the measure of market value) depends upon the discounted future benefits that the marginal unit of money is expected to bring. The valuation model for money highlighted below suggests that the market value of money is positively correlated with long-term expectations of real output and negatively correlated with long-term expectations of base money.

Value of Money and Long Term Expectations

In simple terms, the value of a fiat currency depends upon the expected long-term prosperity of the society that issues it. Currently, the markets are very optimistic regarding the long-term prospects of the United States. But if the Fed blinks and that faith is tested, then the value of money could decline quickly, leading to a return of inflation.

On a final note, there is one more compelling reason for the Fed to unwind quantitative easing: the magician always needs to keep something up their sleeve.

If the US economy was to plunge into recession today, what could the Fed do? Increase the monetary base by a further $4 trillion? At some point, the markets will realize that the Fed is out of bullets (or at least one’s that work). At this point, the value of money will collapse, inflation will return and the Fed will lose any control over economic outcomes. This is the “unthinkable” and a scenario that none us want to experience.

In summary, The Fed needs to act now. It’s time to get back on the treadmill. If we don’t choose to do it now, we will only be forced to do it later.

What Determines the Velocity of Money?

  • In this article, I hope to provide readers with a new perspective on one of the great enigmas of economics: the velocity of money. Using some of the basic concepts discussed in previous articles, we will derive a simple model for the velocity of money and examine the implications of this model.
  • Velocity of Money ModelThis simple model for the velocity of money can be used to demonstrate that the velocity of base money is a dependent variable. More specifically, fluctuations in the velocity of base money merely reflect changes in the total market value of real output (VG q) relative to the total market of the monetary base (VM M).
  • Moreover, the velocity of money is critically dependent upon the value of money. In the slide above, we isolate the “market value of money” VM by measuring the market value of money in absolute terms using a “standard unit” for the measurement of market value. If the value of money VM falls, then, all else remaining equal, the velocity of money of money must rise. If money is less valuable (in the absolute) and there is the same amount of base money outstanding, then the monetary base must turn over more times to cover the value of the transactions in the economy.
  • At the end of this post, we will briefly discuss a more complex expectations-based model for the velocity of money that is derived from the Discounted Future Benefits Model for Money (a valuation model for money developed in The Velocity Enigma).

Introduction: A New Perspective on the Velocity of Money

The velocity of money is a key concept in economics, primarily because the velocity of money is one of four critical variables in the famous “equation of exchange”. Consequently, any quantity theory of money depends upon some assumption or theory regarding the behavior of the quantity theory of money.

Early proponents of the quantity theory of money argued that the velocity of money was relatively stable over the long term and, therefore, an increase in money supply that was in excess of a corresponding increase in real output over a certain period of time would lead to a rise in the price level.

While quantity theory remains a very useful concept over very long-term time horizons, it fails to be useful in any horizon less than 10-15 years because of the large variations that occur in the velocity of money. The velocity of money (or more specifically, the velocity of the monetary base) has experienced enormous swings over the past fifty years.

Velocity of Money is a Dependent VariableDespite much debate and discussion, economics has largely failed to produce useful models for forecasting major shifts in the velocity of money. The focus of this week’s post is to apply the basic principles of The Enigma Series to derive a simple equation for the velocity of money. Hopefully, this simple model for the velocity of money will provide readers with a better understanding of the key drivers of the velocity of money.

While we will discuss this model in more detail later, there are two key points that I want to highlight.

First, the velocity of base money is merely a ratio, a ratio that reflects the total absolute market value of real output transacted in a given period relative to the total absolute market value of the monetary base. If the absolute market value of the monetary base falls, say due to a fall in the absolute market value of money VM , then the monetary base must turn over more times in order to achieve the same absolute market value of transactions (VG q). The key to understanding this point is noting that the market value of goods and money can be measured in absolute terms (in terms of a standard unit for the measure of market value), a concept that we shall discuss shortly.

Second, the velocity of money is a dependent variable. In other words, rising velocity of money does not cause inflation; rather, it is simply a dependent variable that responds to changes in other causal variables (it is the changes in these other variables that cause inflation). This view echoes the thoughts of Henry Hazlitt who wrote an article titled “The Velocity of Circulation” (1968) in which he concludes by noting that the “velocity of circulation is a result, not a cause.” Hazlitt further notes that the velocity of money is “a passive resultant of changes in people’s relative valuations of money and goods”, a notion that is clearly supported by the equation above.

In order to understand the simple model for the velocity of money, one must understand how the property of market value can be measured in both the absolute and the relative. So, let’s briefly discuss the measurement of market value and then use this to derive the simple model for the velocity of money.

Deriving a Simple Model for the Velocity of Money

The process of deriving our model for the velocity of money is very simple, however, the conceptual logic behind the model is not. At issue, is the concept of “market value”, or, more specifically, the various ways in which the property of market value can be measured.

The view expressed in The Inflation Enigma, the second paper of The Enigma Series, is that every price is a relative expression of market value. A “price” is merely one method of measuring the market value of a particular economic good. More specifically, it is a way of measuring the market value of one good in terms of the market value of another good.

The problem with measuring the market value of one good (the “primary good”) in terms of the market value of another good (the “measurement good”) is that the market of the measurement good is not constant. The price of the primary good, in terms of the measurement good, can rise either because (i) the market value of the primary good rises, or (ii) the market value of the measurement good falls.

The Inflation Enigma posits that there is an alternative way to measure the property of market value and that is in terms of a theoretical and invariable measure of market value called “units of economic value”. A unit of economic value is merely an invariable measuring stick of market value, just as an “inch” is an invariable measuring stick of length.

By measuring the market value of goods in terms of this invariable measure of market value, we have a way to measure what one might call the “absolute market value” of each good.

Price as Ratio of Two Market ValuesThe price of the primary good, in terms of the measurement good, can now be expressed in mathematical terms as illustrated in the slide opposite

In our modern money-based economy, the measurement good mostly commonly used to measure the market value of other goods is money. Every “money price” is nothing more than a relative expression of the market value of a good relative to the market value of money. In other words, the price of a good depends upon both the market value of the good itself and the market value of money. As the market value of money falls, then, all else remaining equal, the price of the good, in money terms, will rise.

Ratio Theory of the Price LevelThis microeconomic theory of price determination can be easily extended to a macroeconomic theory of price level determination called the “Ratio Theory of the Price Level”. In essence, Ratio Theory states that if the market value of money is the denominator of every “money price” in the economy, then the market value of money must be the denominator of the price level.

If the market value of money VM falls, then the price level rises. Conversely, if the overall absolute market value of goods VG falls (for example, due to global competition in goods markets), the price level falls.

Derivation of Velocity of Money ModelOnce “Ratio Theory” is established, deriving the simple model for the velocity of money is very straightforward. First, we take the equation of exchange. Then, we substitute for the price level p in the equation of exchange with the ratio of two absolute market values described by Ratio Theory. Finally, we rearrange this new equation to solve for the velocity of money.

What Determines the Velocity of Money?

We can use this simple model for the velocity of money to think in broad terms about what causes changes in the velocity of base money.

The model presented above suggests that the velocity of the monetary base depends on four key variables. Let’s think about how a change in each of these variables, all else remaining equal, might impact the velocity of base money.

  1. Real output (“q”): all else remaining equal, if real output increases, then the velocity of money must increase. This should be a common sense result: if there is more activity in the economy, then each unit of base money needs to circulate more times.
  2. Monetary base (“M”): all else remaining equal (most notably, the market value of money), if the monetary base increases, then the velocity of the monetary base will fall. We have seen a good example of this phenomenon in recent times: as the Fed increased the monetary base, the velocity of money fell.
  3. The market value of money (“VM”): all else remaining equal, a fall in the value of money will lead to a rise in the velocity of money. The logic is simple: if there is a certain value of transactions to be done in the economy (VG q) and a fixed amount of base money (M), then a fall in the market value of money (VM) will necessitate a rise in the number of times each unit of base money must change hands in order for all the transactions in the economy to be completed.
  4. The market value of the basket of goods (“VG”) or the “general value level”: all else remaining equal, if the absolute market value of the basket of goods VG falls, then each unit of money needs to change hands fewer times in order to complete the total absolute market value of transactions in the economy.

The simplified examples above each assume “all else remaining equal”. But what happens if a change in one of the four variables also causes a change in another of the four variables. For example, what happens to the velocity of money if an increase in the size of the monetary base triggers a fall in the value of money?

In this scenario, it will depend on the relative moves. If the value of money falls by less (in percentage terms) than the increase in the monetary base, then the velocity of money will fall. However, this fall in the velocity of money will still be accompanied by an increase in inflation. Why? Assuming the absolute market value of goods is constant, inflation will rise because the value of money has fallen (see Ratio Theory slide).

Velocity of Money is a Dependent VariableAs discussed earlier, this simple model for the velocity of money accords with Hazlitt’s general idea that the velocity of money is a dependent, not a causal, variable. Moreover, the velocity of money merely reflects the relative valuation of goods and money. In general terms, as the total value of economic activity rises, the velocity of money rises. Conversely, as the total value of the monetary base falls (as measured in absolute terms), the velocity of base money must rise in order to cover the same total value of economic activity.

An Expectations-Based Solution for the Velocity of Money

While this simple model for the velocity of money is interesting, it doesn’t say much about the role of expectations in the determination of the velocity of money. Importantly, it doesn’t have much to say about what determines the market value of money.

The view of The Enigma Series is that the market value of money is determined by a complex set of long-term expectations. This idea has been discussed in two recent posts: “Money as the Equity of Society” and “A Model for Foreign Exchange Rate Determination”.

As discussed in both of these posts, the view of The Money Enigma is that base money represents a long-duration, proportional claim on the future output of society. Using this theory, The Velocity Enigma (the third paper in The Enigma Series) derives a valuation model for money called the “Discounted Future Benefits Model for the Market Value of Money”.

Expectations based solution for the velocity of moneyWe can use this valuation model for money to create an expectations-based solution for the velocity of money

The view explored in The Velocity Enigma is that the value of money depends primarily on the expected future path of the “real output/base money” ratio. Since the velocity of money is negatively correlated with the value of money (remember the simple model above), we can say that the velocity of money is correlated with the expected future path of the “base money/real output” ratio.

Let’s apply that idea to our present circumstances. The monetary base has increased and this has been accompanied by a fall in the velocity of money. Why? The velocity of money has fallen largely because the value of money has remained stable while the monetary base has risen.

However, what happens if the market begins to revise up its expectations for long-term base money growth and revise down expectations for long-term real output growth? The value of money will fall, the price level will rise and the velocity of money will rise.

This is the very real risk that policy makers face today. So far, the price level has remained contained while an increase in the monetary base has been absorbed by a fall in the velocity of money. But should expectations suddenly shift, for example, should the market suddenly become more pessimistic on the outlook for the US economy, the value of money could decline sharply, leading to a sharp rise in the velocity of money and an outbreak of severe inflation.