- If money has value and if the value of money is an important factor in the determination of prices in money terms, then why doesn’t economics officially recognise the value of money as a variable in its equations? Moreover, why doesn’t economics clearly explain the role of the “value of money” in the determination of money prices and foreign exchange rates?

- If you look for the term “value of money” in an economics textbook, you won’t find very much. Indeed, the standard economics textbook has little to say about the “value of money” and its role in price determination.

**The reason for this is simple: economics simply doesn’t recognise “the value of money” as an independent variable.**

- You might ask, “How is that possible? How can economics overlook a concept that seems so fundamental?” The answer to this question is rather complicated, but it boils down to the following.

**In order to isolate the “value of money” as an independent variable, economics needs to measure the property of market value in***absolute terms*. In order to measure market value in absolute terms, economics must adopt a “standard unit” for the measurement of market value, something which economics has not done.

- Almost universally, economics measures the property of “market value” in
*relative terms*. For example, the price of a good, in money terms, is a relative measure of the market value of that good in terms of the market value of money. Similarly, the price level is a relative measure of the market value of the basket of goods in terms of the market value of money.

- In both cases, economics is measuring the market value of a good or goods in terms of the market value of money, i.e. both measurements are relative in nature.

- So, how does economics measure the market value of money? The most common way to do this is something called the “purchasing power of money”. The problem is that the “purchasing power of money” is also a
*relative*measure of market value. More specifically, the purchasing power of money measures the market value of money in terms of the market value of the basket of goods. (The purchasing power of money is simply the reciprocal of the price level, itself a relative measure of value).

- The problem with measuring the value of money in relative terms is that it does not allow us to
*isolate*the “value of money” as an independent variable.

- For example, the purchasing power of money can fall because either (a) the market value of money falls, or (b) the market value of the basket of goods rises. The purchasing power of money does not isolate the value of money as an independent variable: rather, it muddies the waters by mixing the value of money with the value of goods.

- The view of The Money Enigma is that economics can only isolate the value of money as an independent variable by measuring the market value of money in absolute terms, that is to say, in terms of a “standard unit” for the measure of market value.

**Why does this matter? Well, isolating the “value of money” as an independent variable opens a number of doors. First, it encourages us to think about why money has value and what determines that value. Second, it forces us to think about an explicit role for the value of money in the determination of prices and foreign exchange rates. Finally, and most importantly, it allows us to shed new light on existing economic theories such as the quantity theory of money.**

**How Do We Measure the “Value of Money”?**

In our everyday life, most of us are accustomed to measuring the value of goods and services in money terms. An apple is worth one dollar. A taxi ride across town costs twenty dollars. Indeed, money is so universally accepted as a medium of exchange and unit of account that we almost instinctively measure and compare the value of economic goods in money terms.

Therefore, when somebody asks us, “how do you measure the value of money?” most of us need to pause and think for a moment. After all, how do you measure the value of something that is itself used as the measure of value?

The most common answer to this question goes something like this: if we can measure the value of goods in money terms, then we can measure the value of money in goods terms.

The value of money, in terms of the basket of goods, is known as the “purchasing power of money” and it is a popular method for measuring the value of money.

Another way to measure the value of a currency is to measure it in terms of a different currency. A foreign exchange rate is, in essence, a way of measuring the value of one type of money in terms of another type of money.

The purchasing power of money and foreign exchange rates both represent valid ways of measuring the “value of money”. However, there is a problem with this approach. Both of these measures are *relative *measures of value.

The purchasing power of money measures the market value of money in terms of the market value of the basket goods. A foreign exchange rate measures the market value of money in terms of the market value of another currency. In both cases, we are measuring the value of money in relative terms and, therefore, both measures are dependent upon not only the value of money, but also the value of the measurement good (the basket of goods or the other currency).

In other words, we have not isolated the “value of money” as an independent or standalone variable. Why this matters is something that we will discuss later, but first let’s consider how we might isolate the value of money as a standalone variable.

**The Measurement of Market Value: Absolute versus Relative**

If a physical property can be measured in *relative terms*, then it can also be measured in *absolute terms*. If we can measure the market value of money in relative terms, then we should also be able to measure the market value of money in absolute terms. Moreover, by measuring the market value of money in absolute terms, we can isolate the value of money as an independent variable.

What does all this mean? Well, let’s start by thinking about the difference between *absolute* and *relative* measurement.

Every measurement we ever make is an act of comparison. In this sense, every measurement is relative: we are comparing one thing with another thing. However, by convention, science designates some measurements to be *absolute* in nature, while others are *relative* in nature.

**The key difference between an absolute versus a relative measurement is the unit of measure being used.**

**A measurement is considered to be an absolute measurement if it is done using a “standard unit” of measure. The key characteristic of a standard unit of measure is that it is invariable in the property that is being measured.**

For example, an inch is a standard unit of length. An inch is invariable in the property of length and can be used to measure length and/or height in absolute terms.

**In contrast, a relative measurement is merely the measurement of one object, the primary object, in terms of another, the measurement object. Most importantly, a relative measurement does not require that the second object, the measurement object, is invariable in the property being measured.**

For example, if I measured the speed of one car on the road in terms of another car on the road, then that would be a relative measurement of speed (i.e. one car is going twice as fast as the other car). The second car (the measurement car) is not invariable in the property of speed, therefore the measurement can not be considered to be absolute.

**In summary, the difference between an absolute measurement and a relative measurement is that an absolute measurement can only be made using a “standard unit” of measurement.**

The interesting thing about standard units is that they tend to be theoretical in nature. Standard units don’t occur naturally in the real world: rather, we had to make them up. Feet, inches, pounds and kilograms were all standard units of measure that we created.

**And this brings us back to the main point of this article: economics needs to create a standard unit for the measurement of market value.**

Every economic good possesses the property of market value. If a good did not possess the property of market value, then we would not exchange it in trade.

**In theory, we should be able to measure the market value of a good in both absolute and relative terms.**

**Almost universally, economics measures market value as a “price”. But price is a relative measure of market value. The price of one good, in terms of another good, is relative measure of the market value of both goods.**

**However, if economics adopts a standard unit for the measurement of market value, then we can measure the market value of each good in absolute terms (in terms of the standard unit).**

Why would we want to do this?

Measuring market value in absolute terms allows us to isolate changes in the market value of one good from changes in the market value of another good. In the most basic terms, it gives us greater insight into what is really driving the change in the price of a good.

Price is a relative measurement of market value. This means that the price of one good (the primary good) in terms of another good (the measurement good) can rise for one of two basic reasons. Either (a) the market value of the primary good rises, or (b) the market value of the measurement good falls.

**By measuring market value in absolute terms, we have a better way of tracking what caused the rise in the price of the good. We can track whether the price rise was caused by (a) the primary good becoming more valuable, or (b) the measurement good becoming less valuable.**

This notion becomes particularly important when we discuss the determination of prices in money terms.

**At the most fundamental level, the price of a good in money terms measures of the market value of that good in terms of the market value of money.**

We can easily express this basic concept in mathematical terms if we measure the market value of the good and money independently, i.e. if we measure the market value of each in terms of a standard unit.

**The price of a good in money terms can rise because either (a) the value of the good V(A) rises or (b) the value of money V_{M} falls. **

**Note that the value of money is the denominator in our price equation: as the value of money falls, the price of the good rises.**

The notion that the price of a good depends upon the value of money may seem like a very simple idea, but it is a fundamental concept and one that can only be expressed once the value of money is isolated by measuring it standard unit terms.

**The Value of Money: Shedding New Light on Old Ideas**

So, what are some of the interesting applications of this concept? What are the tangible benefits of isolating the value of money as an independent variable?

Let’s begin with the basics. The price equation in the slide above begs a couple of obvious question. First, what determines the market value of money? Second, if money has value and if the value of money plays a key role in price determination, then how do we incorporate it into traditional supply and demand analysis?

The traditional microeconomic view is that the price of a good is determined by supply and demand for that good. So, what role does the value of money play?

In order to incorporate the value of money into traditional supply and demand analysis, we need to rethink the unit of measurement that is used on the y-axis of our supply and demand diagrams.

**The view of The Money Enigma is that every price is determined by two sets of supply and demand.**

The price of a good in money terms is a relative expression of the market value of the good and the market value of money. The market value of a good is determined by supply and demand for that good. The market value of money is determined by supply and demand for money (the monetary base).

**Therefore the price of the good in money terms is a function of both supply and demand for the good and supply and demand for money.**

The key to illustrating this point is the way that we measure market value on the y-axis. In the slide above, market value is not measured in price terms, but is measured in terms of the standard unit, i.e. market value is measured in absolute, not relative terms.

**This representation of price determination described above can be easily reconciled with the traditional representation of supply and demand once it is recognised that traditional supply and demand analysis implicitly assumes that the market value of the measurement good is constant.**

For example, let’s take the supply and demand diagram for good A that is on the left hand side of the slide above. If you assume the market value of money *V _{M}* is constant and you divide all y-axis values for

*V(A)*by the market value of money

*V*, then you end up with the traditional version of the supply and demand representation for good A with the price of good A on the y-axis.

_{M}Similarly, we can convert the traditional supply and demand diagram with price on the y-axis into standard unit terms by multiplying all y-axis values by the market value of the measurement good, which, by the way, is already assumed to be constant in traditional supply and demand analysis.

The theory that every price is a function of two sets of supply and demand is discussed at length in a recent post titled “A New Economic Theory of Price Determination” and on the “Price Determination” page of this website.

**If you are not an economist and you are wondering why this matters, then I will give you at least one good reason.**** **

**According to this theory of price determination, supply and demand for money (the monetary base) determines the market value of money, not the interest rate.**

**If this is correct, then Keynes’ liquidity preference theory, a cornerstone of modern economics, is wrong. This is an idea was discussed in a recent post titled “Supply and Demand for Money: Where Keynes Went Wrong”.**

From a more constructive perspective, if the market value of money is the denominator of every money price in the economy, then this has important implications for macroeconomic theories of price level determination.

At the most basic level, we can use this idea to construct what is 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. Therefore, the price level can be expressed as a ratio of two market values.

**Ratio Theory highlights the importance of isolating the “value of money” as a variable. The value of money is the denominator in our price level equation above: as the value of money falls, the price level rises.**

**Moreover, Ratio Theory provides with a way to shed new light on old theories such as quantity theory of money. For example, does an expansion in the monetary base lead to an increase in prices because (a) it drives higher levels of economic activity and a rise in the value of goods, or (b) does an expansion in the monetary base lead to a decline in the value of money?**

The application of Ratio Theory to the quantity theory of money is discussed in a recent post titled “Saving Monetarism from Friedman and the Keynesians”.

**What Determines the Value of Money?**

Before we conclude, it is worth spending a little more time talking about what determines the market value of money.

As illustrated above, the view of The Money Enigma is that supply and demand for the monetary base determines the market value of money. Technically, it is my opinion that this is a fair and accurate description of how the value of money is determined. However, in practice, this description leaves a lot to be desired.

The reason for this is that the value of money depends primarily upon long-term expectations of key economic variables. It is difficult to capture the complexity of these long-term expectations and their impact on the market value of money in a simple supply and demand diagram.

If you are interested in reading more about why fiat money has value and how the value of fiat money is determined, then I would highly recommend reading “The Evolution of Money: Why Does Fiat Money Has Value?” and “What Factors Influence the Value of Fiat Money?”

Author: Gervaise Heddle, heddle@bletchleyeconomics.com