What Determines the Value of a Currency?

January 19, 2016

The view of The Money Enigma is that the value of a fiat currency is primarily determined by market confidence in the long-term economic future of the nation that issued that currency.

When confidence in a nation’s long-term economic prospects are strong, the value of its currency tends to be well supported. However, if confidence is damaged, for example by war or economic mismanagement, then the value of the currency will fall. In an extreme scenario, one where the economic survival of a nation is questioned, the value of a currency can collapse resulting in a condition known as “hyperinflation”.

Ultimately, fiat currency is only as good as the society that issues it. In this article, we shall explore why this is the case and why the value of a nation’s currency tends to fluctuate with perceptions regarding its economic future.

However, before we attempt to answer the question “what determines the value of a currency?” we need to answer two fundamental questions. First, why does the value of the currency matter? Second, why does fiat currency have any value at all?

Why Does the Value of the Currency Matter?

The value of the currency plays a critical role in the determination of foreign exchange rates and the price level.

The fiat currency in your pocket has value, i.e. it is “valuable” in the ordinary sense of that word. If fiat currency didn’t possess the property of market value, then you wouldn’t accept it in exchange for your services and others wouldn’t accept it from you in exchange for their goods and services.

If we measured the value of the fiat currency in your pocket in terms of a “standard unit” for the measurement of market value, i.e. in terms of a good that was invariable in the property of market value, then we would be able to observe that the value of that fiat currency rises and falls independently of the value of goods and services and all other currencies.

However, in practice, we don’t measure the value of currency in terms of a theoretical “standard unit”. Rather, we measure the value of the currency in terms of goods and other currencies that are themselves variable in value.

More specifically, we tend to measure the value of a currency in terms of either, (a) another currency, or (b) a basket of goods and services.

The value of one currency as measured in terms of another is known as a “foreign exchange rate”. A foreign exchange rate measures the value of one currency in terms of the value of a second currency.

The value of a currency as measured in terms of a basket of goods is known as the “purchasing power of money”. The purchasing power of money is the inverse of the “price level”, i.e. the price level measures the value of the basket of goods in terms of the value of currency.

A fall in the value of a currency will tend to have two important impacts. First, it will tend to lead to a fall in the price of that currency as measured in terms of other currencies. Second, it will lead to a decline in the purchasing power of money, i.e. prices for most goods will tend to rise.

Why is this the case? Well, if you think about it in simple terms, if each unit of currency in your pocket is suddenly “less valuable”, then, all else remaining equal, you would expect to have to give up more of it in order to obtain the things you want. It doesn’t matter whether those things are goods, services or other currencies: if the currency in your pocket is suddenly less valuable, then you will have to offer more of it to obtain those other items.

The relationship between the value of money and the price level is discussed in more detail in a recent article titled “Ratio Theory of the Price Level”.

In simple terms, Ratio Theory states that the price level can be calculated as a ratio of two values: the value of goods (the numerator) and the value of money (the denominator). All else remaining equal, as the value of money falls, the price level rises.

In summary, fluctuations in the value of money play a key role in the determination of foreign exchange rates and the price level. But why does the paper money in your pocket have any value at all? In order to answer this question, we need to examine the evolution of money.

Why Does Fiat Currency Have Any Value?

If you do a quick search on the question “why does fiat money have value?” you will find a whole range of answers, none of which are particularly compelling.

Indeed, mainstream economics struggles to provide a sensible answer to this question because it treats fiat money as an “exception”. What does this mean? Well, it means that rather than treat fiat money just like any other asset, economists try to invent new schemes and theories that apply solely to fiat money and not to any other assets. Inevitably, this creates a whole series of problems and objections, none of which have been successfully resolved.

Fortunately, there is a simple paradigm that can be used to explain why any asset, including fiat currency, has value: the real asset/financial instrument paradigm.

The real asset/financial instrument paradigm has its roots in accounting, rather than economics, and it is used to explain how any particular asset derives its value.

Real assets versus financial instruments

In essence, the real asset/financial instrument paradigm states that assets can only derive their value in one of two ways. Real assets derive their value from the physical properties. In contrast, financial instruments derive their value from their contractual properties.

In simple terms, if an asset doesn’t derive its value from its natural or intrinsic properties, then the only way it can derive its value is if it creates an obligation on a third party to deliver something of value.

Fiat currency is not a real asset. Rather, fiat currency is a financial instrument and derives it value from its implied contractual properties. More specifically, fiat currency represents a liability of society and claim on the future output of society.

Fiat money liability of society

In order to understand this point, it helps to think about how money evolved over time. [Readers that are interested in a more in-depth discussion of the evolution of money should read “The Evolution of Money: Why Does Fiat Money Have Value?”]

The first form of money used by early societies was “commodity money”, i.e. a commodity that found acceptance as a medium of exchange and unit of account. This early form of money was a real asset and derived its value from its natural physical properties. Over time, precious metals such as gold and silver became the most popular form of commodity money and were widely accepted across international borders.

At some point, kings and governments began to issue paper notes that represented promises to deliver gold and/or silver on request. This first paper money, know as “representative money” derived its value from its contractual properties. Suddenly, money was a financial instrument, i.e. it had value because it created an obligation on a third party (the king) to deliver something of value (gold/silver).

Ultimately, representative money, money backed by a real asset, limited the amount of money that kings and governments could create. Therefore, at some point, the gold convertibility feature was removed and “representative money” suddenly became “fiat money”.

In theory, this creates a problem. By removing the gold convertibility feature, the explicit contract that governed paper money was rendered null and void. So why did paper money maintain any value at all?

The view of The Money Enigma is that paper money only maintained its value when the gold convertibility feature was removed because the explicit contract that governed paper money was replaced by a new implied-in-fact contract or what some might call a “social contract”.

The key question is what is the nature of this new implied social contract? If fiat money is a financial instrument and can only derive its value contractually, then it must represent a liability to a third party. So, how is that third party and what obligation does it create against them?

What Determines the Value of Fiat Currency?

The view of The Money Enigma is that fiat currency derives its value from an implied social contract. Fiat currency is an asset to its holder because it represents a liability to society. Although government is the legal issuer of fiat currency, from an economic perspective, fiat currency is a liability of society and represents a claim against the future output of society.

More importantly, fiat currency represents a proportional or variable claim against the future output of society. What does this mean? Well, it helps to think about the general nature of financial instruments.

In general terms, a financial instrument represents either a fixed or proportional claim to some future economic benefit. For example, a corporate bond represents a fixed claim to the future cash flows of a business. In contrast, a share of common stock represents a proportional claim to the future residual cash flows of a business.

What determines the value of common stock? There are two key drivers. First, the expected cash flows that will be generated by the business: a share of common stock is a claim to those cash flows, so clearly the future level of those cash flows matters. Second, the expected number of shares outstanding in the future: if the market expects shares outstanding to skyrocket in the future, then each share will claim a smaller proportion of future cash flows and, all else remaining equal, will be worth less.

We can apply these same ideas to fiat currency.

Fiat currency represents a proportional claim on the future output of society. More specifically, the expected proportion of future output that fiat money will claim in any future period depends upon the expected future size of the monetary base at that time.

Now we can answer our key question: “What determines the value of fiat currency?”

If fiat currency represents a proportional claim on future output, there are two key drivers that influence the current value of fiat money.

The first is obvious: the value of fiat currency is positively correlated to the outlook for future output growth. If fiat currency represents a proportional claim against future output, then its value must be tied to optimism regarding the ability of the economy to grow.

The second is less obvious: the value of fiat currency is inversely related to expectations regarding the future size of the monetary base. If fiat currency represents a proportional claim against the future output of society, then its value will rise if people start to believe that long-term monetary base growth will be restrained and its value will fall if people suddenly believe that long-term monetary base growth will accelerate.

Value of Fiat Money

If this seems like a complicated idea, then consider what drives the price of common stock.

Ultimately, the price of common stock depends upon expectations regarding the long-term future path of earnings per share. Similarly, the value of fiat currency depends upon expectations regarding the long-term future path of real output per unit of money.

What does this mean in practice?

In practical terms, this theory implies that the value of fiat currency is primarily determined by confidence in the long-term economic future of the nation that issued that currency.

When confidence in the long-term economic future of society is high, people tend to expect solid real output growth to be accompanied by a disciplined expansion of the monetary base. This type of environment is very supportive for the value of fiat currency.

In contrast, if confidence in the long-term economic future of society is damaged, then people might reasonably expect lackluster economic growth or even economic contraction to be accompanied by aggressive expansion of the monetary base. This type of environment can lead to a significant fall in the value of the currency, an outcome that is typically reflected in both foreign exchange rates and the price level (prices rise across the economy).

One of the compelling aspects of this theory of fiat currency is that we can use it to build an expectations-based valuation model for fiat currency (see slide below). In turn, this can be used to build expectations-based solutions for foreign exchange rates, the price level and the velocity of money.

Value of Money and Long Term Expectations

Readers who are interested in this valuation model for money should read the “Theory of Money” section of this website and an older post titled “A Model for Foreign Exchange Rate Determination”.

Author: Gervaise Heddle