The view of The Money Enigma is 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 only one set of supply and demand, namely supply and demand for the primary good. For example, the traditional view is that the price of apples is determined by supply and demand for apples.

The problem with this perspective is that it underplays the critical role played by the measurement good. More specifically, in order for the primary good to be priced in terms of the measurement good, both goods must possess the property of market value.

The view of The Money Enigma is that the *market value* of a good is determined by supply and demand for that good. The market value of the primary good is determined by supply and demand for the primary good. The market value of the measurement good is determined by supply and demand for the measurement good.

The *price* of the primary good, in terms of the measurement good, is a relative expression of market value: the market value of the primary good in terms of the market value of the measurement good.

Therefore, the price of the primary good, in terms of the measurement good, is determined by *both* supply and demand for the primary good *and* supply and demand for the measurement good.

This theory represents a *universal theory of price determination*: it applies to the determination of prices in a barter economy (“good/good” prices), prices in a money-based economy (“good/money” prices) and foreign exchange rates (“money/money” prices).

The slide opposite demonstrates one important implication of this theory: supply and demand for the monetary base determines the market value of money, the denominator of every money price in the economy. Supply and demand for money (the monetary base) does not determine the interest rate, as suggested by Keynes’ liquidity preference theory.

**The Measurement of Market Value**

In order to appreciate this theory of price determination, it is critical that one understands the difference between the *relative* and *absolute* measurement of market value.

Every measurement is an act of comparison. What differentiates an “absolute” measurement from a “relative” measurement is the nature of the *unit of measurement*.

A measurement is considered to be *absolute* if the measurement is conducted using a “standard unit of measurement” for the particular property being measured. For example, inches are considered to be a standard unit of length.

In order for something to be a standard unit for measurement it must (a) possess the property being measured, and (b) it must be *invariable* (constant) in that property. Most things in nature aren’t invariable; therefore, most standard units of measure are theoretical (we made them up to help us measure things).

In contrast, a measurement is considered to be *relative* if the measurement is not conducted using a standard unit. In other words, the property being measured is measured with something that is itself variable in the property being measured.

The property of “market value” is predominantly measured on a *relative* basis. For example, one apple is twice as valuable as one dollar, therefore the price of an apple is two dollars: *this “price” is a relative measure of the market value of the two items being exchanged (apples and dollars)*. Importantly, the measurement good, the dollar, is itself variable in the property of market value.

However, we should also be able to measure the property of market value in absolute terms, at least theoretically. We can do this by creating a standard unit for the measurement of market value. The standard unit can be thought of as a theoretical good that possesses market value and, more importantly, is *invariable* in market value.

By adopting a standard unit for the measurement of market value, we can measure the market value of goods independently (we don’t need to measure the market value of one good in terms of another good that is itself variable in the property of market value) and we can isolate and analyze the market value of each good separately.

Furthermore, measuring market value in terms of a standard unit allows us to demonstrate that every price can be considered to be a function of two sets of supply and demand. As we will see, this notion is particularly useful in discussions regarding the determination of the market value of money and the determination of money prices.

**Price is a Relative Measure of Market Value**

In every transaction, there are at least two goods that are exchanged. Both of these goods must possess the property of “market value” in order for a successful exchange to occur. In a free and efficient market, the market value of both baskets being exchanged must be equal. [In a free and efficient market, no one is going to sell goods for less than they are worth, or buy goods for more than they are worth].

Let’s assume there are two goods, A and B. Assume that we can measure the market value of each good in terms of the standard unit of market value (as discussed above). The market value of good A, as measured in temrs of the standard unit, is denoted as *V(A)*. The market value of good B, as measured in terms of the standard unit, is denoted as *V(B)*. Let’s also denote the quantity of good A and good B exchanged as *Q(A)* and *Q(B)* respectively.

The “Principle of Trade Equivalence” states that, in a free and efficient market, the market value of the basket of good A will be equal to the market value of the basket of good B exchanged.

The price of good A, in terms of good B, or “*P(A _{B})*”, is merely the ratio of

*Q(B)*divided by

*Q(A)*, (every price is a ratio of two quantities exchanged). By rearranging the equation, we can see that the price of A in B terms is also equal to the ratio of the market value of good A divided by the market value of good B.

The price of A in B terms is a *relative* measure of the market value of *both* goods. If the market value of A rises, then the price of A in B terms *rises*. Conversely, if the market value of B rises, then the price of A in B terms *falls*.

We can apply this theory to demonstrate that every price is a function of two sets of supply and demand.

The price of the primary good, in terms of the measurement good, is a relative expression of the market value of the two goods. In turn, the market value of each good is determined by supply and demand for that good. Therefore, the price of the primary good, in terms of the measurement good is determined by *both* (a) supply and demand for the primary good, *and* (b) supply and demand for the measurement good.

The key to illustrating this concept is the use of the *standard unit* as the unit of measure on the y-axis. Traditionally, supply and demand diagrams use price on the y-axis. The problem with this traditional approach is that price is a relative measure of market value: for the traditional supply and demand diagram to be meaningful, it must assume that the market value of the measurement good is constant. By measuring market value in absolute terms (using the standard unit) we don’t need to assume that the market value of the measurement good is constant.

Let’s consider some practical applications for this theory.

**Price Determination in a Barter Economy**

Let’s imagine that we live in a barter economy with two goods, apples and bananas. Does the price of apples, in banana terms, depend on (a) supply and demand for apples or (b) supply and demand for bananas? The answer is (c), both!

Let’s put it another way. Does the price of bananas, in apple terms, depend upon (a) supply and demand for bananas, or (b) supply and demand for apples? Again, the answer must be “both”.

In essence, both of the questions above are asking the same thing. In both cases, the ultimate question being asked is “what is the ratio of exchange of the two goods, apples and bananas?” It can’t be that this ratio of exchanged is determined by supply and demand for apples if expressed one way, and determined by supply and demand for bananas if expressed in another way. The ratio of exchange is determined by *both* sets of market forces.

We can illustrate this phenomenon by using our standard unit of market value and plotting supply and demand for apples and bananas *independently* of each other.

On the left hand side, supply and demand for apples determines the market value of apples. On the right hand side, supply and demand for bananas determines the market value of bananas. The price of apples, in banana terms, is determined by the ratio of the market value of apples, denoted *V(A)*, divided by the market value of bananas, denoted *V(B)*. Alternatively, the price of bananas, in apples terms, is determined by *V(B)* divided by *V(A)*.

**Price Determination in a Money-Based Economy**

We can apply this same principle to the determination of “money prices” (the price of goods expressed in money terms). In our modern money-based economy, one of the two goods normally being exchanged is money. Money performs a critical role as the “measurement good” in most transaction.

The price of a good, in money terms, is a relative expression of *both* the market value of the good *and* the market value of money. The market value of the good is determined by supply and demand for the good. The market value of money is determined by supply and demand for money (technically, the monetary base). Therefore, the money price of a good is determined by two sets of supply and demand: supply and demand for the good itself *and* supply and demand for money.

The notion that supply and demand for money determines the market value of money, the denominator or every “money price”, represents a direct challenge to the Keynesian theory that supply and demand for money determines the interest rate (liquidity preference theory). The determination of the market value of money is discussed at length in the next section, “Money and Inflation”.

**Foreign Exchange Rate Determination**

The principle that every price is a function of two sets of supply and demand also applies to the determination of “money/money prices” or, as they are more commonly known, foreign exchange rates.

For example, the USD/EUR exchange rate (Dollar per Euro, or the price of Euros in Dollar terms) is a relative expression of the market value of the Euro in terms of the market value of the US Dollar. Moreover, the USD/EUR exchange rate is determined by two sets of supply and demand: supply and demand for Euros and supply and demand for US Dollars.

While this may be interesting, it doesn’t really tell us much about what factors influence foreign exchange rates. In the next section, we discuss a valuation model for money that can be used to develop an expectations-based model for foreign exchange rates.

**Ratio Theory of the Price Level**

We can extend this microeconomic theory of price determination to the macroeconomic level. More specifically, we can use the notion that every price is a relative expression of two market values to develop a basic theory of price level determination called “Ratio Theory of the Price Level”.

Ratio Theory states that the price level measures the market value of the basket of goods in terms of the market value of money. In mathematical terms, the price level *p* is a ratio of the market value of the basket of goods (denoted *V _{G}*) divided by the market value of money (denoted

*V*). Both the market value of the basket of goods and the market value of money are measured in absolute terms (in terms of the standard unit of market value).

_{M}The market value of the basket of goods is the numerator of the price level. All else remaining equal, a fall in the market value of the basket of goods will lead to a fall in the price level.

The market value of money is the denominator of the price level. All else remaining equal, and fall in the market value of money will lead to a rise in the price level.

The Money Enigma develops an adapted version of aggregate demand and supply analysis called “The Goods-Money Framework”. On the left hand side, the market value of the basket of goods *V _{G}* is determined by aggregate supply and demand. On the right hand side, supply and demand for the monetary base determines the market value of money

*V*, the denominator of the price level.

_{M}**Recommended Money Enigma Articles**

If you are interested in learning more about these theories, then I would highly recommend the following articles.

“The Measurement of Market Value: Absolute, Relative and Real” discusses a subject that is critical to a thorough understanding of price determination. I would strongly encourage you to read it. I simply can’t overstate how important this topic is.

“A New Economic Theory of Price Determination” and “Every Price is a Function of Two Sets of Supply and Demand” both provide a good overview of the microeconomic theory discussed above.

Price determination in a barter economy is discussed in several posts. “Is the Price of Apples Determined by Supply and Demand for Bananas?” contains examples of price determination in a barter economy. “The Matrix of Prices in a Barter Economy” provides a high level view of how prices are determined in a barter economy. “Price Determination in a Barter Economy” also provides a good overview of the theory.

“A Model for Foreign Exchange Rate Determination” discusses the basic application of this theory to foreign exchange rates.

At a macroeconomic level, “Ratio Theory of the Price Level” provides a basic overview of price level determination. Another post that breaks down the issue of price level determination into simple terms is “Inflation or Deflation: A Microeconomic Perspective”.

**Other Reading**

The following articles and books are highly recommended.

David Ricardo’s “Note on Absolute Value and Exchangeable Value” is a must read for those interested in the measurement of market value. Although Ricardo doesn’t propose a standard unit for the measurement of market value, he does clearly recognise that price is a relative measure of the market value of two goods. The history associated with this paper is fascinating. Although it was written in 1823 it wasn’t published until 1951.

I would highly recommend reading the first 15 pages of Benjamin Anderson’s book “The Value of Money” (1917). In this first chapter, Anderson comes close to proposing a “standard unit” for the measurement of market value. Unfortunately, Anderson never attempts to apply this concept to supply and demand analysis. Anderson also has something very interesting things to say about why money can perform its functions in Chapter VII (“Dodo-Bones”): in essence, money doesn’t derive value from its functions, rather money can only perform its function because it has value.

Mark S.A suggestion…

I love your theory – it explains some mysteries regarding inflation and deflation that weren’t explained with my current understanding.

However, it’s possible it’s missing a small piece. Various Austrian oriented commentators make the point that a trade doesn’t happen unless both parties feel they’re getting BETTER than fair value. This would necessitate yet another dual variable in the theory to fully explain things: each party has an independent assessment of the value of money and also the value of the good.