Tag Archives: deflation

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

In last week’s post, we reviewed the theory that price is a relative expression of two market values. For example, the price of bananas, in money terms, depends upon both the market value of bananas and the market value of money. If the market value of bananas rises, the price of bananas rises. Conversely, if the market value of money rises, the price of bananas falls.

In more technical terms, we explored the idea that the price of one good, as measured in terms of another good, depends upon both the market value of the first good (the “primary good”) and the market value of the second good (the “measurement good”).

This week we will extend this idea and explore the theory that every price is determined by not one, but two, sets of supply and demand: supply and demand for the primary good, and supply and demand for the measurement good.

In simple terms, the key elements of this theory can be described as follows:

  1. Every price is a relative expression of two market values (the market value of the “primary good” and the market value of the “measurement good”);
  2. The market value of a good is determined by supply and demand for that good; therefore,
  3. Every price is determined by two sets of supply and demand, namely, supply and demand for the “primary good” and supply and demand for the “measurement good”.

Price Determination TheoryThis universal theory of price determination is illustrated in the diagram opposite.

The price of good A in good B terms, denoted P(AB), is a function of the market value of good A, denoted V(A), and the market value of good B, denoted V(B). Supply and demand for good A determines the market value of good A, V(A). Supply and demand for good B determines the market value of good B, V(B). Therefore, 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.

Some readers may be thinking that this just can’t be right. After all, doesn’t supply and demand for a good determine its “price”, not its “market value”?

The key point that I would make here is that the model above is compatible with the standard supply and demand theory taught at college. The “price” of a good is just one way of measuring the “market value” of that good. More specifically, the “price” of a good is the market value of that good as measured in terms of the market value of another good.

Traditional supply and demand analysis, with “price” on the y-axis, simply assumes that the market value of the “measurement good” is constant. We want to be able to relax that assumption and analyze the impact on the price of a good if supply and/or demand change not just for the “primary good”, but also for the “measurement good”.

In order to understand how it is possible to represent a price as a function of two sets of supply and demand, we need to think about the different ways in which the property of “market value” can be measured.

Market value can be measured in absolute or relative terms. We are so accustomed to thinking of market value in relative terms (in terms of a “price”) that we struggle with the notion that market value can be measured in absolute terms. But all properties can be measured in either absolute or relative terms.

For example, let’s think about the property of “height”. The property of height can be measured in either absolute or relative terms.

Let’s imagine that we have a girl standing next to a tree. The tree is three times taller than the girl.

Typically, we might measure the height of the girl in inches. An “inch” is an invariable and universal measure of height. Similarly, we can measure the height of the tree in inches. By measuring the height of the girl and the tree in inches, we have measured the height of both in terms of an invariable and universal measure of height. In this sense, we have measured the height of both the girl and the tree in “absolute” terms.

But there is another way to measure the height of either the girl and/or the tree and that is in “relative” terms. For example, we could measure the height of the tree in girl terms. The tree is three times taller than the girl. Hence, the height of the tree, in girl terms, is three girls.

Similarly, we could measure the height of the girl in tree terms. The girl’s height is one-third of a tree.

Does the girl’s height change if we measure it in “absolute” terms (in terms of inches) or in “relative” terms (in terms of the tree)? No. The girl’s actual height doesn’t change. All that has changed is the way in which we measure her height.

We can apply this same principle to the property of “market value”.

“Market value” is a property of economic goods (goods that are traded in our economy). If goods do not possess “market value”, then they are not traded and there is no price for them.

The market value of goods can be measured in absolute terms or in relative terms. Typically, we measure the market value of goods in relative terms. More specifically, we measure the market value of most goods in terms of the market value of money. For example, a banana is twice as valuable as one dollar and hence the price of a banana is two dollars. This “price” is a relative expression of the market value of bananas relative to the market value of money.

However, we can, at least theoretically, measure the “market value” of each good in absolute terms. Just as we measure height in absolute terms, in terms of an invariable measure of height such as inches, so we can measure market value in terms of an invariable measure of market value.

However, since no good possesses the property of invariable market value (the market value of all goods varies over time), we need to create some theoretical measure of market value that is invariable. The Inflation Enigma proposes a standard for this called “units of economic value” or “EV” for short. Units of economic value are just like feet or inches, except that instead of measuring the height of an object, they measure the market value of a good.

Once we have created this standard and invariable measure of market value (“units of economic value”), we can measure the market value of all goods, including money, in absolute terms. More importantly, we can illustrate supply and demand for each good in absolute terms.

Price Determined by Two Sets Supply and DemandIn the diagram opposite, the price of good A in money terms is illustrated as a function of two markets. On the left hand side, supply and demand for good A determines the market value of good A. Note that the unit of measurement being used on the y-axis is not money (a relative measure of market value) but units of economic value (an absolute measure of market value).

On the right hand side, the market value of money is also being measured in terms of our theoretical and invariable measure of market value (units of economic value). Supply and demand for money determines the market value of money (not the interest rate!).

The price of good in A, in money terms, is a relative expression of both the market value of good A and the market value of money. Therefore, the price of good A is determined by two sets of supply and demand: supply and demand for good A (the “primary good”) and supply and demand for money (the “measurement good”).

Let’s quickly examine what happens if there is an increase in demand for good A. If demand for good A increases, the demand curve for A (on the left hand side of the diagram) will shift to the right and the equilibrium market value of good A will rise. Furthermore, if the market value of money is constant (there is no change on the right hand side of our diagram), then the price of good A will rise.

This is the standard outcome generated by traditional supply and demand analysis. In this sense, the model above is perfectly consistent with traditional microeconomic theory.

However, what happens if demand for money increases? In this scenario, the demand curve for money (on the right hand side of the diagram) shifts to the right and the market value of money rises.

Now, what happens to the price of good A in money terms? The price of good A falls.

There has been no change in supply and/or demand for good where supply and demand are expressed in terms of our invariable measure of market value. However, the price of good A will fall because the market value of the measurement good (money) has risen.

The theory that every price is determined by two sets of supply and demand is one of the key theories developed in The Inflation Enigma, the second paper in The Enigma Series.

It is important to note that this theory is a universal theory of price determination. It can be applied to price determination in a barter economy (“good/good” prices), price determination in a money-based economy (“good/money”) prices) and foreign exchange rate determination (“money/money” prices).

The Inflation Enigma extends this microeconomic theory of price determination to a macroeconomic theory of price level determination called the “Ratio Theory of the Price Level”. Ratio Theory is particularly helpful in framing discussions regarding the causes of inflation.

Inflation or Deflation: A Microeconomic Perspective

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:

  1. “Price” and “market value” are not the same thing; and
  2. 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.

Price DeterminationIn 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.

Price as Ratio of Two Market ValuesAnd this brings us to our key point: price is a relative expression 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”.

Price Determination Barter EconomyIn 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).

Ratio Theory of the Price LevelWe can extend this microeconomic concept of price determination to a macroeconomic discussion of inflation.

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).

Inflation or Deflation: Which is the Greater Risk in 2015?

Could 2015 be the year the markets experience both a “deflation scare” and an “inflation scare”?

The recent collapse of crude oil prices below $60 per barrel, combined with additional signs of global economic weakness, have renewed fears about an outbreak of deflation in the United States. Six years have passed since the US Federal Reserve first embarked on its current path of quantitative easing. The US Federal Reserve’s balance sheet has increased five-fold and other global central banks have followed in their footsteps. Despite this remarkable growth in the global monetary base, inflation has remained subdued.

The view of many in financial markets is that global deflationary forces are just too strong and that global central banks are increasingly impotent in their battle against deflation. This also seems to the view of at least one dissenter at the US Federal Reserve, Fed “dove” and Minneapolis Federal Reserve Bank President, Narayana Kocherlatkota, who argued that the Fed should be willing to further expand the monetary base if inflation continues running below the Fed’s 2% target.

While it may not be explicitly acknowledged by those who hold these deflationary expectations, this represents a quintessentially “Old Keynesian” perspective regarding the way the world operates. In essence, it is the view that if aggregate demand is weak, then prices must fall. Moreover, if global competition is pushing the aggregate supply curve to the right, then this only compounds the deflationary pressures.

The problem with this view is that it represents a very “one-sided” perspective on how “money prices” are determined in our economy. While it is true that well-entrenched deflationary forces (i.e., falling oil prices, global economic stagnation, and increasing global competition) have, and will probably continue to, put downward pressure on the value of global goods and services, there is a key element that is missing from our analysis: the future path of the value of money.

The value of money is the denominator of every “money price” in the economy. Every money-based transaction involves an exchange of two items of value. When you buy your morning cup of coffee, you receive one good of value and, in exchange, offer another good of value in return. This is the simple principle of all economic transactions dating all the way back to the barter economy of our ancestors. In our modern money-based society, the good of value that you offer in exchange for your morning cup of coffee is money.

The price of your morning coffee can rise for one of two basic reasons: the value of a cup of coffee can rise, or the value of money can fall. If the value of money falls, then, all else remaining equal, your local coffee shop will require you to give them more dollars for that morning cup of coffee.

We can extend this simple concept to the price level and changes in the price level (inflation). The value of money is the denominator of every “money price” in the economy and therefore the denominator of the price level. As the value of money falls, the price level rises.

In simple terms, this is the “Ratio Theory of the Price Level”, an economic theory of price level determination developed in The Enigma Series. Ratio Theory suggests that any “inflation versus deflation” debate needs to begin with a simple equation. Mathematically, the price level “p” can be described as a function of the value of goods and services “VG” and the value of money “VM” (see image below).

Ratio Theory of the Price Level

Inflation can be thought of as a game of “tug-of-war” between these two opponents. Currently, the world is experiencing strong deflationary forces that are placing downward pressure on the numerator in our equation, the value of goods and services. The current fall in oil prices should only accentuate these forces.

The bigger question relates to the future path of the value of money? The value of money has been relatively stable over the past few years, despite the massive expansion in the monetary base. However, is it reasonable to expect this stability to continue? And if the value of money does fall, then will it overwhelm the steady decline in the value of goods and services? In other words, will the denominator in our equation fall by more than our numerator?

You may ask why economics doesn’t present the “inflation/deflation” debate in these simple terms. Mainstream economics struggles with the concept outlined above because it does not recognize “the value of money” as a variable in its equations. In technical terms, economists struggle with the notion that price is a relative expression of two market values (the market value of a primary good as expressed in terms of the market value of a measurement good). Moreover, economics has largely failed to recognize that the property of “market value” can be thought of in both “absolute” and “relative” terms.

But before we get carried away with economic theory, let’s return to the topic at hand. What is the inflation outlook for 2015?

It seems reasonable to believe that the current weakness in the oil price, should it be sustained, will have some flow through effects over the course of the first few months of 2015. Energy costs represent a significant input cost for many industries and lower oil prices should contain any inflation over the next few months.

However, it seems unlikely that deflation represents the greatest risk to investors in the second half of 2015. Rather, the greatest risk to long-term investors remains a sudden collapse in the value of money and a significant jump in the rate of inflation. Indeed, 2015 may be remembered as a “flip-flop” year: fears of deflation in the first-half of the year rapidly switch to fears of inflation in the second-half of the year.

So, what is the risk of a sudden collapse in the value of money in 2015?

After six years of experimentation with the monetary base, many investors have been lulled into a false sense of security regarding this issue. The view of some investors is that if QE was going to negatively impact the value of the US Dollar, then it would have already happened by now. However, this is a naïve and simplistic view.

Ultimately, the value of a fiat currency is a function of the confidence that markets have in the long-term economic prospects of the society that issued it. More specifically, the value of money reflects expectations regarding the long-term path of the “output/money” ratio.

Over the past few years, markets have become more optimistic regarding the long-term prospects for the US economy. The view is that the US economy will continue to grow strongly over the next 10-20 years, even as the monetary base is “normalized” from its current extended levels.

However, if confidence in this view is shaken, then the value of the US Dollar will come under pressure. For example, if the Fed does reduce the monetary base, even modestly, and this results in a recession in the US, then investors’ long-term confidence in the path of the “output/money” ratio could be quickly shaken. The question for all investors is whether 2015 is the year that confidence turns.

Clearly, the role of expectations in the determination of the value of money and the price level is a complicated matter and future articles will be dedicated to exploring this issue further.

So, is deflation or inflation a greater risk in 2015? Near term, the risks may be on the side of deflation. But longer term, the risks are squarely in the inflation camp.