Tag Archives: the value of money

The Interest Rate is Not the Price of Money

This week we will explore one of the most poorly understood concepts in economics: the price of money. More specifically, what does supply and demand for money determine?

The traditional textbook view, as originally developed by John Maynard Keynes, is that supply and demand for money determines the interest rate. This simple notion lies at the heart of all modern macroeconomics. While some economists have disputed this notion, particularly those in the Austrian tradition, few have offered a sensible alternative.

The reason that Keynes’ liquidity preference theory has stood for so long is that offering a sensible alternative this theory requires an overhaul of the current microeconomic theory of price determination. In particular, if supply and demand for a good determines the price of that good, then how can supply and demand for money be incorporated in microeconomic price determination?

The key intellectual leap that needs to be made is recognizing that every price is a function of two sets of supply of demand. The price of one good (the primary good) in terms of another good (the measurement good) is a function of both supply and demand for the primary good and supply and demand for the measurement good.

Price Determination Theory

The view of The Money Enigma is that supply and demand for money determines the market value of money, the denominator of every “money price” in the economy.

Price Determined by Two Sets Supply and Demand

Economists struggle with supply and demand for money because economics has not developed a sensible paradigm for the measurement of “market value”. As a result, current models of price determination present a very “one-sided” of the price determination process.

Every price is a relative expression of two market values. If the market value of one banana is three times the market value of one dollar, then the price of bananas, in dollar terms, is “three dollars”.

Supply and demand for a good determines that good’s market value. However, in order for us to calculate the price of a good, in terms of another good (such as money), we need to know the market value of that second “measurement good”. The market value of this measurement good is determined by supply and demand for that measurement good.

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 trick to understanding this concept is recognizing that the property of “market value” can be measured in both absolute and relative terms. All properties can be measured in absolute or relative terms. For example, the speed of a car can be measured in absolute terms (in terms of some invariable measure of speed such as “miles/hour”), or in relative terms (in terms of some other object that possesses the property of speed, for example, the car is doing twice the speed of the bus).

Market value can also be thought of in absolute or relative terms. The way we experience market value in every day life is in “price” terms. Price is a relative measure of market value. For example, “the price of the banana is three dollars” is a way of measuring the market value of bananas in terms of another good that possesses the property market value, namely “the dollar”.

However, both the banana and the dollar must possess the property of market value and we can measure the market value of each good individually in terms of an invariable measure of market value (just as the speed of the car and the bus can both be measured in terms of “miles/hour”, an invariable measure of speed).

In the diagram below, the price of Good A, in money terms, is determined by two sets of supply and demand. On the y-axis, market value is measured in absolute terms, that is to say, in terms of a theoretical and invariable measure of market value, or what one might call a “standard unit” of market value.

Price Determined by Two Sets Supply and Demand

The price of good A, in money terms, can rise for one of two basic reasons. Either, the market value of good A can rise, or the market value of money can fall. For example, if demand for money falls, then the demand curve on the right side of our diagram shifts downward and the market value of money falls. What happens to the price of good A? The price of good A, in money terms, rises. Why? Because price is a relative expression of two market values.

Let’s circle back around to our original question. What is the price of money?

This is not a straightforward question because price is a relative expression of two market values. Therefore, the first follow up question that needs to be asked is the price of money in terms of what? What is the measurement good?

We can measure the price of money in banana terms. For example, if the price of bananas in money terms is three dollars, then the price of money in banana terms is one-third banana.

Alternatively, we might measure the price of money in terms of a basket of goods. The price of the basket of goods, in money terms, is the price level. The price of money, in terms of the basket of goods, is the inverse of the price level, also commonly referred to as “the purchasing power of money”.

Therefore, we can’t say that the price of money is the price level, but we can say that the price of money is the inverse of the price level.

What we can’t say is that “the price of money is the interest rate”.

If you step back and look at the history of economics, it becomes clear why Keynes posited that supply and demand for money determines the interest rate.

Keynes was a pupil of the great Alfred Marshall, author of “Principles of Economics” (1890), a book that did more than any other to popularize the notion that the price of a good is determined by supply and demand for that good.

But Marshall’s work left one question unanswered. If supply and demand for a good determines the price of a good, then what does the supply and demand for money determine?

If you don’t recognize, as Keynes did not, that every price is, in fact, a function of two sets of supply and demand, then this leaves you looking for candidates. The only plausible candidate that Keynes could find was “the interest rate”.

Despite the fact that it should have been clear to Keynes (and all modern day economists) that the interest rate is determined by supply and demand for bonds, Keynes came up with his awkward justification of the notion that supply and demand for money determines the interest rate.

Just to be clear, it is perfectly correct to say that central bank operations can influence the interest rate. If a central bank creates money and uses it to buy bonds, then the demand curve for bonds shifts to the right and the price of bonds rises (the interest rate falls).

What is not correct is to say that since these central banking operations influence the interest rate, that supply and demand for money determines the interest rate.

The view of The Enigma Series is that every price is a function of two sets of supply and demand. Supply and demand for money determines the market value of money, the denominator of every “money price” in the economy. We can measure the market value of money in absolute terms (in terms of our invariable measure of market value, “units of economic value”). Alternatively, we can measure the market value of money in relative terms: this is “the price of money” in terms of some other good, basket of goods or even other currency. The point is that there are multiple ways to measure the price of money, but none of them are “the interest rate”.

I would encourage all those who are interested in a critique of liquidity preference theory and an alternative view on price determination to read The Enigma Series.

A Bubble of Confidence Obscures the Risk of Inflation

A quick scan of recent financial headlines would suggest that the Western World is on the verge of a major contraction in prices. One commentator after another argues that deflation is the great risk to global economies and markets.

Ironically, the current period of relatively low inflation is the flipside of the overvaluation in global bond and equity markets. More specifically, there is a bubble of confidence in all asset classes. This bubble of confidence is supporting not only debt and equity markets, but supporting the value of the major fiat currencies. It is this overconfidence in money that is keeping a lid on the price level in the major Western economies and helping to drive the price of commodities (and gold in particular) to new lows.

The Federal Reserve’s unprecedented actions since the 2008 crisis have led to a surge in confidence regarding the long-term economic prospects of the United States (and thereby the long-term prospects of the world economy). The notion that the United States is steaming ahead and will pull the rest of the world with it is a common theme in current financial market commentary.

This surge in confidence regarding the long-term outlook has permeated global asset markets. Government bond prices have soared (particularly in the European periphery ex-Greece) and this has fed a search for yield in corporate debt. Prospective risk-adjusted, nominal returns on a broad portfolio of global government and corporate debt are close to 0%. (You don’t have to have many positions go wrong in a global fixed income portfolio with an ex-ante 2-2.5% headline yield for the ex-post yield to be 0%).

Furthermore, as prospective fixed interest returns have collapsed, investors have chased global equities higher and higher to the point where prospective ten-year nominal returns on the US equity market are also close to 0%. (See John Hussman’s commentary for an excellent discussion of this issue replete with long-term valuation charts).

More interestingly, this surge in confidence has supported the market value of fiat money, the denominator of every “money price” in the economy and thereby suppressed prices as stated in money terms. Despite the massive increase in the US monetary base, the market value of the US Dollar has been supported by a surge in confidence regarding the long-term prospects of the US economy.

Why has the US Dollar seemingly ignored the massive increase in the monetary base? And why has the market value of the US Dollar been so sensitive to a surge in market confidence regarding the long-term economic future of the United States? The answer to both questions is that money is a long-duration, proportional claim on the output of society.

The theory developed in The Money Enigma, the first paper in The Enigma Series, is that money is a long-duration, proportional claim on the future output of society. In essence, what this means is that the value of money today depends upon expectations of what the ratio of real output to base money will be over the next 20-30 years. The ratio of output/money as it stands today is somewhat irrelevant to the value of money. What matters is the expected path of that ratio over the next 20-30 years.

Let’s break down this concept into its two main components.

  1. Money is a long-duration asset

If an asset is described as being a long-duration asset, then all this means is that a large part of the current value of the asset is tied up in benefits that should be received from that asset in the distant future. For example, a 30-year government bond is a long-duration asset because the principal repayment on that bond is not due for 30 years and the interest payments are spread out over the next three decades.

Money is a long-duration asset because its current market value depends largely upon benefits that will be received from spending that money in the distant future. More specifically, in a state of intertemporal equilibrium, we are indifferent between spending the marginal unit of money demanded now, in 5 years from now or in 20 years from now. (If this were not the case then the economy would not be in a state of intertemporal equilibrium). This somewhat complicated notion is explored at length in The Velocity Enigma, the final paper in The Enigma Series. Fortunately, there is a simpler way to think about this issue. The value of money depends upon a chain of expected future values.

When I buy a product from you and give you money in exchange, you expect that the money I give you should have a similar purchasing power (a similar market value) when you spend it. When you spend the money, the next person accepts it because they believe it will have a similar future purchasing power. This process continues all the way down a chain of thousands of people.

Therefore, if the market suddenly decides that money will have less value in some distant future period, then that will have an immediate impact on the current value of money.

Conversely, if the market is optimistic in regards to the future of money, then that confidence will support the current value of money, even if the monetary authority has recently created a lot more money (does this sound familiar?).

The point is that money is a long-duration asset and its value today depends upon future expectations. But future expectations of what? This brings us to the second part of the earlier statement.

  1. Money is a proportional claim on the output of society

Money is a financial instrument. This means that money derives its value contractually. More specifically, money is a special-form equity instrument issued by society (money is a legal liability of government, but an economic liability of society) and money represents a proportional claim on the future output of society. The view of The Enigma Series is that an implied-in-fact contract exists between the issuer of money (society) and the holders of money (again, society) that recognizes money as a proportional claim on the future output of that society.

Money is much like a share of common stock. One share of common stock is a proportional claim on the future cash flows of a company. If the number of claims rises (the number of shares on issue rises), then all else equal, the value of each claim falls. Similarly, if the expected future cash flows of the company fall, then the value of each proportional claim on those cash flows falls (the current value of each share falls).

Money is a proportional claim on the future output of society. If the number of claims rises (the monetary base increases), then all else equal, the value of each claim will fall. However, if the expected future output of society rises, then this will increase the value of the proportional claim on that future output (the value of money rises).

In summary, money is a claim on the future output of society and the current market value of money depends upon expectations of the long-term path of the “real output/base money ratio”.

So, how does a surge in confidence regarding the future prospects of a country impact the value of the currency issued by that currency? Clearly, such confidence will support the market value of that currency.

The near-term path of the “output/money” ratio is fairly irrelevant to the value of money. If the market expects the monetary base to decline over the next ten years and economic output to continue to grow strongly over that period, then that confidence is enough to support the value of money and, conversely, keep a lid on inflation.

However, there is a risk.

If confidence in the future prospects of the US collapse, then we would naturally expect the bond and equity markets to suffer. However, such a collapse in confidence will also impact the market value of the US Dollar.

As discussed in last week’s post, every price is a relative expression of the market value of two goods. If the market value of money suddenly declines, then, all else remaining equal, the price of all goods, in money terms, will rise sharply.

The markets are not prepared for this eventuality. But the prospect of a sudden and severe increase in the rate of inflation is a far more likely than a return of 1930s-style deflation. All it will take is one pin that pops the bubble of confidence that currently permeates all global asset markets.

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).