Why Money Is Valuable, And Why It Loses Value

Posted: Mar 12, 2019 10:57 AM
Why Money Is Valuable, And Why It Loses Value

Money is an economic good used as a medium of exchange, and as such, requires particular characteristics. Things that lose value quickly, like bread, don’t make good money. A house is not used as money because it is not portable and it is not divisible. You can’t buy a theater ticket with a handful of stones, because common rocks are not valuable. They are everywhere, and scarcity relative to demand is what gives anything its value. The most important aspect of any money is that it is accepted by trading partners, and they will not likely accept something as money without a good idea that what they are getting has some stable, predictable value.

In the United States, the dollar is the generally accepted medium of exchange. Everyone accepts it, whether in coin, paper, checking account withdrawals, credit cards, or other electronic transactions. When someone makes a trade for dollars, they know pretty well how much value they are getting. In other words, they have some idea about what those dollars will buy when they use them to trade for other things.

In the United States and pretty much any country with a functioning government, the domestic currency is the most generally accepted medium of exchange primarily because legal tender laws outlaw competing currencies, and because contracts using anything but dollars as the consideration will not likely survive a court challenge. Such countries have what are called fiat currencies, where the word fiat means a decree or dictate by the government. A fiat dollar is only money because government decrees it so. It is not back by or redeemable in any other asset.

The danger of fiat currency is that governments have the ability to create massive amounts of money out of nothing and cause hyperinflation, as has happened in multiple countries in recent history. In those cases, people tend to find other methods of exchange, even if they are illegal, and black markets proliferate. Even though the dollar has been significantly devalued over time, it is still stable enough for people to make their decisions.

As an economic good, money is subject to the laws of supply and demand. The price of money is the inverse of the price of goods it can buy.  As the supply of money increases, the price of money tends to decrease. That means that you can buy dollars with fewer goods. The inverse of that means that it takes more dollars to purchase a set of goods, a description of price inflation.

A counter-argument is often offered that history suggests that there is no such connection, because, in spite of a tremendous increase in the money supply since the Great Recession, consumer prices have stayed pretty tame. What, however, can dollars buy? Consumer goods and services, yes, but also farms and factories, machines, corporate stocks, bonds, and derivatives, government securities, illegal drugs, prostitution services, and so on. The prices of these other things have not all been tame. The Russell 3000, a broad index of the stock market, which is a large chunk of the financial assets, has more than tripled from March of 2009. Is there anyone who says that a 368% price increase in ten years is not significant inflation? That, and other financial assets, is where the extra dollars have gone, primarily because of perverse political and monetary incentives.

A lot of conflicting factors are in play in the present economy, and how it will turn out in time is anybody’s guess. What nobody can coherently say is that there has been no inflation in the prices of everything that money can buy. Supply and demand determine price, even for money, and even though it is spread unevenly across the economy.