In this week’s post we shall consider a basic question: “why does the price level rise and fall?” This might seem like a simple question, but a roomful of economists probably couldn’t agree on a succinct answer to that question.
Rather than entering into an extended macroeconomic debate about the causes of inflation, we shall attempt the answer the question “why does the price level rise and fall?” by considering the issue from a microeconomic perspective.
More specifically, we shall consider a couple of the key microeconomic ideas developed in The Enigma Series, namely:
- “Price” and “market value” are not the same thing; and
- Price is a relative expression of two market values.
The key to understanding inflation (a macroeconomic phenomenon) is a comprehensive theory of price determination (a microeconomic phenomenon). After all, if we understand how one price is determined, then surely we should be able to understand how many prices are determined?
While many inflation commentators prefer to jump straight into a discussion of macroeconomic variables (i.e., the output gap and oil prices), very few begin by answering a couple of the most basic questions in economics, namely “what is a price?” and “how is a price determined?”
If you ask most economists “what determines the price of a good?” the standard answer you will receive is “supply and demand for that good”. However, this represents a very one-sided view of the price determination process.
In contrast, the view of The Enigma Series is that every price is determined by two sets of supply and demand: supply and demand for the ‘primary good’, and supply and demand for the ‘measurement good’. More specifically, every “money price” is determined by two sets of supply and demand: supply and demand for the good itself and supply and demand for money.
Before you say, “that’s impossible” or “that’s not what I was taught at college”, let’s step back and answer the first question.
What is a price?
Every price is a ratio of two quantities exchanged. For example, x dollars for y bananas, is the price of bananas in dollar terms. This is a “good/money” price. But the same principle extends to barter prices, or “good/good” prices, and foreign exchange rates, or “money/money” prices.
For example, in a barter economy (an economy with no money), the price of bananas in apple terms could be three bananas per apple. Again, it is just a ratio of two quantities exchanged (a quantity of bananas for a quantity of apples).
Similarly, a foreign exchange rate (i.e., the EUR/USD cross rate) simply represents the quantity of one currency exchanged for a certain quantity of another currency exchanged.
The point is that every economic transaction involves, at minimum, an exchange of two items (bananas for money, bananas for apples, Euros for US Dollars) and the “price” of the transaction is the ratio of the quantities of the two items exchanged.
Now, let’s move on to the more complicated second issue. How is this “ratio of quantities exchanged”, or “price”, determined?
In order to answer this question, it helps to think about what property a good must possess in order for it to “have a price”. For example, why does coffee have a price but sunshine does not? Most people would simply say that sunshine is “free”. But at a more fundamental level, the reason there is a price for coffee and not a price for sunshine is that coffee possesses the property of “market value”, whereas sunshine does not possess the property of “market value”.
For a good to have a price, it must possess the property of “market value”.
Frankly, this proposition should be rather obvious. What may not be as obvious is that for prices to be measured in terms of a particular good (the “measurement good”), that good (the “measurement good”) must possess the property of market value.
In other words, for any good (“good A”) to measure the market value of another good (“good B”), the first good (“good A”) must possess the property of “market value”. It is impossible to determine the price of B in A terms unless A possesses the property of market value.
Let’s consider our coffee versus sunshine example to illustrate the point.
If we chose to, we could measure the market value of all things in terms of coffee beans. For example, the price of bananas might be tens coffee beans, and the price of an apple might be six coffee beans. Coffee beans possess the property of market value and we can measure the market value of other items in the economy in “coffee bean terms”.
Now, could we express all prices in the economy in “sunshine terms”?
The short answer is “no”, but why?
Why is it impossible to express the price of apples or bananas or any other economic good in terms of units of sunshine? The reason that we can’t express prices in “sunshine terms” is because sunshine does not possess the property of market value.
In any simple two-good exchange, the price of the transaction depends upon the market value of the “primary good” and the market value of the “measurement good”.
If one unit of the “primary good” (for example, one banana) is three times as valuable as one unit of the “measurement good” (for example, one dollar), then the price of the primary good, in measurement good terms, is three units of the measurement good per one unit of the primary good (or, in the case of our example, three dollars per banana).
If the “measurement good” does not possess the property of market value, then we can’t express prices in terms of that good. We can only use money as a “measurement good” for our prices because it possesses the property of market value. Clearly, we can’t use sunshine as our measurement good (we can’t express prices in sunshine terms), because sunshine doesn’t possess market value.
So, let’s return to the main issue. What determines the price of one good, the “primary good”, in terms of another good, the “measurement good”? Is the price determined by the market value of the primary good, or is the price determined by the market value of the measurement good? The answer is “both”.
In a barter economy, the price of bananas, in apple terms, depends upon both the market value of bananas and the market value of apples. The price of bananas, in apple terms will rise if the market value of bananas rises. More importantly, the price of bananas, in apple terms, will rise if the market value of apples falls.
Similarly, the price of bananas, in money terms, will rise if the market value of bananas rises or if the market value of money falls. If the market value of money falls, then bananas are relatively more valuable, even if they are not absolutely more valuable. Price is a relative expression of two market values. Hence, the price of bananas, in money terms, will rise if the market value of money falls (all else remaining equal).
In simple terms, rising prices across the economy can be caused either by (1) an increase in the market value of goods and services, or (2) a decrease in the market value of money.
Economic weakness and a fall in oil prices may contribute to a decline in the market value of goods. These are both deflationary pressures that act to lower “money prices” across the economy. However, both of these pressures could be more than offset by a decline in the value of money.
The problem with most “inflation or deflation” debates is that the participants don’t recognize the simple notion that price is a relative expression of market value. Any meaningful discussion must consider not only the forces acting upon the market value of goods (oil price, output gap, etc.), but also the forces acting upon the market value of money (expectations regarding future output growth and base money growth).