Monthly Archives: June 2015

Ratio Theory of the Price Level

Ratio Theory of the Price Level states that the price level is a relative measure of market value. More specifically, the price level measures the market value of the basket of goods in terms of the market value of money.

Mathematically, the price level is a ratio of two variables: the market value of the basket of goods divided by the market value of money.

The numerator is the market value of the basket of goods: all else remaining equal, as the market value of goods rises, the price level rises. The market value of the basket of goods can rise for all manner of reasons, but a couple of reasons might include a sudden increase in aggregate demand (“too much demand”) or a sudden decrease in aggregate supply (“supply shock”).

The denominator is the market value of money: all else remaining equal as the market value of money falls, the price level rises. The market value of money is poorly understood by modern economics because most economists don’t explicitly focus on the “value of money” as a factor in their equations. Indeed, the “market value of money” can only be isolated as a variable if market value is measured in terms of a “standard unit”, i.e. in absolute terms.

The key to appreciating Ratio Theory is understanding two microeconomic concepts: (a) the property of “market value” can be measured in both the relative and the absolute, and (b) every price is nothing more than a relative measurement of two market values, both of which can be measured in absolute terms. In this week’s post we will explore both of these microeconomic concepts and then extend them to develop a macroeconomic theory of price level determination, namely “Ratio Theory of the Price Level”.

Ratio Theory of the Price Level: A Useful Concept for Analysis

There are many competing theories regarding price level determination. Economists trained in the Keynesian school tend to believe that inflation is caused by “too much demand” and that one of the primary roles of the central bank is to manage the economy to ensure that it doesn’t “overheat”.

Monetarists tend to believe that “too much money” is the primary cause of inflation, although many monetarists seem to ascribe to a Keynesian transmission mechanism: “too much money” creates “too much demand” which leads to rising prices. Other economists believe that “too much government debt” is the primary cause of inflation, particularly severe inflation (Fiscal Theory of the Price Level).

Each of these schools of thought suffers from a rather narrow perspective regarding the way the economic world works. Economists have made countless efforts to improve these one-sided models by the inclusion of various “expectation terms”, but this has only led to more vague notions such as the idea that inflation is determined by “inflation expectations” (even if this is the case, what then determines “inflation expectations”?).

The view of The Money Enigma is that all of these schools of thought could improve their models by acknowledging what should be a simple notion: the price level is a ratio of two market values.

The price of a good, in terms of another good, is a relative expression of the market value of both goods. The price of a good, in money terms, is a relative expression of the market value of the good itself and the market value of money. Therefore, the price of the basket of goods, in money terms, (also known as “the price level”) is a relative expression of the market value of the basket of goods in terms of the market value of money.

In mathematical terms, the price level is a ratio: the price level is equal to the market value of the basket of goods (the numerator) divided by the market value of money (the denominator).

We can use this simple model of the price level to ask more probing questions about traditional theories of inflation. For example, does “too much money” create inflation because (a) it increases the level of economic activity and raises the market value of goods (V_G rises), or (b) increases the monetary base relative to economic output thereby reducing the market value of money (V_M falls)?

Similarly, does “too much government debt” lead to rising prices because the fiscal spending increases economic activity (V_G rises as there is “too much demand”) or because markets become fearful about the economic viability of society and the value of the fiat currency issued by that society falls (V_M falls)?

Ratio Theory also provides a good starting point for any “inflation versus deflation” debate. For example, does economic weakness lead to deflation? While economic weakness should put downward pressure on the market value of goods, the other side of the equation (which is often ignored by Keynesians) is what will happen to the market value of money if confidence in the long-term economic prospects of society begins to falter?

While all these questions represent interesting topics for discussion, the primary goal for this week is to explain the concepts behind Ratio Theory. In particular, most economists will probably struggle with the terms V_G and V_M in the equation above.

Both of these terms represent market value as measured in the “absolute”: V_G is the market value of the basket of goods as measured in absolute terms, and V_M is the market value of money as measured in absolute terms.

In order to understand what it means to measure the market value of a good in the absolute, we need to go back to basics and think about the different ways in which scientists can measure physical properties.

The Measurement of Market Value: Absolute versus Relative

The view of The Money Enigma is that “price” and “market value” are not the same thing. While some may believe that these terms are synonymous, there is a subtle but important distinction between the two.

“Market value” is a property possessed by an economic good. For any good to be exchanged in trade that good must be “valuable”, i.e. it must possess the property of “market value”.

The “price” of a good is not a property of that good. Rather, the price of the good is a way of measuring the property of “market value”. More specifically, price is a relative measure of the market value of a good: a price measures the market value of one good (the primary good) in terms of the market value of another good (the measurement good).

If price is a relative measure of market value, then this raises an interesting question: “Is it possible to measure market value in the absolute?”

In order to answer this question, we need to go back one more step and answer a more general question: “What does it mean to measure any property in the absolute?”

Fortunately, science has a well-established paradigm that distinguishes between the absolute measurement of a property and the relative measurement of a property.

The act of measurement is, by definition, an act of comparison. In this sense, all measurements could be considered to be “relative”. However, even though all measurements involve an act of comparison, scientists designated some measurements as being absolute while others are relative.

So, what does it mean to say that a measurement is “absolute”?

A measurement is considered to be “absolute” if we measure something compared to a “standard unit” of measurement.

What makes something a “standard unit” of measurement?

In order for something to perform as a standard unit for the measurement for a certain property, there are two key characteristics that thing must possess. First, it must possess that property. Second, it must be invariable in that property.

These are the two key characteristics of a standard unit of measurement, but there is a third characteristic that most standard units possess: most “standard units” of measurement are theoretical.

Let’s think about this in the context of a simple example: the measurement of height.

We can measure the height of a building in absolute or relative terms. For example, we can say that one building is twice as tall as another building. This is a relative measurement of height.

In contrast, we can measure the height of the building in absolute terms. In order to do this, we need a standard unit for the measurement of height, such as “feet and inches”. Feet and inches are standard units of height: they posses the property of height and they are invariable in that property. Therefore, if we measure the height of the building in feet and say it is 250 feet tall, then that is an absolute measurement of the height of the building.

What we should also note about this example is that feet and inches are theoretical units of measure. The length of one “inch” is not something that exists in nature. We made it up. We decided, on a fairly arbitrary basis, that the length of one inch is “about that much”.

This is true of most standard units of measure: one hour, one mile, one kilogram – they are all theoretical measures of a particular property that we made up to help us measure various physical properties.

Why are most standard units of measurement theoretical? The reason we use theoretical entities as standard units of measure is because nearly everything in nature is variable. By definition, we can’t use objects that are variable in a property as “standard units” of measurement for that property.

In summary, the key difference between an “absolute” and a “relative” measurement is the unit of measure being used. In the case of an absolute measurement, we use a “standard unit” of measure. Most standard units are theoretical units of measure and, importantly, they must be invariable in the property that they are measuring.

In contrast, a relative measurement is merely a comparison of one object (the primary object) with another (the measurement object): it does not require that the second object (the measurement object) is invariable in the property being measured.

Now, let’s return to the main topic at hand: the measurement of market value.

Can we measure the property of “market value” in the absolute? The answer is yes, at least theoretically. But in order to measure market value in the absolute, we need to create a standard unit for the measurement of market value.

Unfortunately, a standard unit for the measurement of market value must be theoretical in nature. Why? It must be theoretical because there is no real-life good that is invariable in the property of market value.

So, what is the key advantage of measuring market value in the absolute? By adopting a standard unit for the measurement of market value, we can now measure the market value of each good independently of the market value of other goods.

Let’s use a simple example: the price of apples in money terms. Let’s assume that the current price of apples is two dollars per apple. This ratio exchange implies that one apple is worth twice as much as one dollar.

Now, let’s assume that next year the price of apples rises to three dollars per apple. What can we say about the market value of apples and the market value of dollars?

What we can say for certain is that the value of one apple has risen relative to the value of one dollar. One apple is now worth three times as much as one dollar.

But what can we say about the value of apples? Has the value of apples risen or fallen? From the facts provided, we can’t answer this question. We know that the relative value of apples has risen, but we can’t say whether the absolute value of apples has risen or fallen.

The price of apples could have risen either because (a) the market value of apples rose, or (b) because the market value of money fell.

In order to know whether the price of apples rose because of (a) or (b) above, we need some way to measure the market value of each good independently from other goods. Our standard unit for the measurement of market value gives us a means to make this type of absolute measurement.

Price as a Ratio of Two Market Values

Introducing a standard unit for market value for the property of market value allows us to measure the market value of goods independently of each other. The key advantage of this approach is that it allows us to express price as a ratio of two market values.

The view of The Money Enigma is that price is a relative measurement of market value. This is hardly a new concept. Adam Smith in “The Wealth of Nations” (1776) seeks to explore the rules that “determine what may be called the relative or exchangeable value of goods”. While Smith may not have explicitly stated that “price is a relative expression of market value”, it was clear that Smith considered price to be “relative” in nature.

Nevertheless, what does it mean to say, “Price is a relative measure”?

In simple terms, if the price of an apple is two dollars, then this implies that the market value of one apple is twice that of one dollar. The money price of an apple is merely a measure of the market value of an apple relative to the market value of a dollar.

This is simple concept, but how do we express this in mathematical terms? The key is measuring the market value of apples and money independently using the standard unit of market value that we discussed earlier.

Let’s think about this in general terms.

If the market value of good A as measured in terms of our standard unit is denoted as V(A) and the market value of good B as measured in terms of the standard unit is denoted as V(B), then the price of good A, in good B terms, is merely the ratio of V(A) divided by V(B). The price of A, in B terms, can rise either because (1) the market value of A rises, or (2) the market value of B falls.

If “good A = apples” and “good B = money”, then we can say that the price of apples, in terms of money, depends on both the market value of apples and the market value of money.

Importantly, the market value of money is the denominator of the price of apples. All else remaining equal, if the market value of money falls, the price of apples, as measured in money terms, will rise.

Moreover, this is observation is true for every “money price” in the economy: the market value of money is the denominator of every money price in the economy.

The price of apples, the price of bananas, the price of milk… all of these prices, as expressed in money terms, are determined by both the market value of the good itself (apples/bananas/milk) and the market value of money. All else remaining equal, if the market value of money falls, then the price of all these goods, as measured in money terms, will rise.

We can take this one step further.

The price level is a hypothetical measure of the price of the “basket of goods”. In a simplified sense, the price level is an index of prices. If every price in that index is a function of a numerator (the market value of the good) and a denominator (the market value of money), then it follows that the price level itself is a function of a numerator (the market value of the basket of goods, denoted V_G) and a common denominator (the market value of money, denoted V_M). [The market value of the basket of goods V_G can be thought of as an output-weighted index of market values for the goods contained in the basket of goods, where market value is measured in terms of the standard unit.]

The Market Value of Money

Ratio Theory raises an interesting question. Namely, what determines the market value of money, the denominator of the price level?

Economics has largely failed to answer this question because most economists have failed to ask it. Mainstream economics does not have any variable called the “value of money” or the “market value of money” in its equations.

The reason for may not be obvious, but in essence, if you don’t recognize that market value can be measured in the absolute using a standard unit for the measurement of market value, then you can’t isolate the “value of money” as a variable.

Economists will talk about the “purchasing power of money”, but the purchasing power of money is a relative expression of the market value of money. The purchasing power of money is merely the inverse of the price level, itself a relative measure of market value.

The Enigma Series develops a theory of money that might be used to help think about the determination of the market value of money called “Proportional Claim Theory”. In essence, the view of The Enigma Series is that money is a long-duration, special-form equity instrument that represents a proportional claim on the future output of society.

Moreover, The Enigma Series uses this theory to develop a “valuation model” for money. Importantly, this valuation model is expressed in “standard unit” terms and is the first model to solve for the value of money as measured in the absolute. This valuation model for money can also be used to create expectations-based solutions for the price level, the velocity of money and foreign exchange rates.

Readers who are interested in exploring these concepts further should read “Money as the Equity of Society” and “What Factors Influence the Value of Fiat Money?”

If you would like to learn more about Ratio Theory, then please visit the Price Determination section of The Money Enigma or read The Inflation Enigma, the second paper in The Enigma Series.

Author: Gervaise Heddle, heddle@bletchleyeconomics.com

Supply and Demand for Money: Where Keynes Went Wrong

The notion that “supply and demand for money determines the interest rate” is an idea that seems innocuous and entirely plausible. In fact, it is a very dangerous and misleading idea: an idea that has sent the science of economics on an 80-year journey down the wrong path.

The fundamental problem with this Keynesian theory is that it implicitly denies a role for the market value of money in the determination of “money prices”. The view of The Money Enigma is that supply and demand for money determines the market value of money. In turn, the market value of money is the denominator of every “money price” in the economy. (As the market value of money falls, prices rise).

Let’s start with what should be a simple concept: “every price is a relative expression of the market value of the two items being exchanged”. Think about a simple trade in which two items are exchanged, for example, a certain amount of money for a certain number of apples. Both items being exchanged (apples and money) must possess the property of market value in order for a trade to occur (no is going to part with something of value for something that has no value).

The ratio of exchange of one item for another (also known as the “price” of the trade) depends upon the market value of the first good (apples) relative to the market value of the second good (money). For example, if an apple is three times as valuable as one dollar, then the price of an apple is three dollars.

If this theory of price determination is correct, then something must determine the market value of money. By far the best candidate for this role is supply and demand for money (or, more specifically, supply and demand for the monetary base).

Where Keynes went wrong is that he assumed that every price is determined by only one set of supply and demand. For example, he assumed that the price of apples is determined solely by supply and demand for apples. Therefore, supply and demand for money, to Keynes’ mind, doesn’t have a direct role to play in the determination of the price of apples.

The view of The Money Enigma is that this traditional model is wrong: every price is a function of not one, but two sets of supply and demand. In terms of our example, this means that the price of apples, in money terms, is determined by both supply and demand for apples and supply and demand for money.

In summary, supply and demand for money can determine only one of two things: either it can determine the interest rate (Keynesian view), or it can determine the market value of money (Money Enigma view). It can’t determine both. If you choose “the interest rate”, then implicitly you are denying any role for the value of money in the determination of money prices.

Liquidity Preference Theory: a Naïve and Dangerous Idea

Keynes’s liquidity preference theory states that supply and demand for money determines the interest rate. It is one of the core theories of modern economics and stands largely unchallenged in orthodox economics circles to this day.

The view of The Money Enigma is that liquidity preference theory represents a naïve and dangerous view about the nature of money and the role of money in the price determination process. Moreover, liquidity preference theory has only survived because microeconomics has failed to develop a sensible theory of universal price determination (a theory of price determination that can be applied to the determination of all prices, not just money prices).

We will explore these assertions in more detail in a moment. But first, let’s step back to the year 1935, the year John Maynard Keynes wrote “The General Theory of Employment, Interest, and Money” and think about why Keynes might have come up with the notion that supply and demand for money determines the interest rate.

Keynes was a student of the great economist Alfred Marshall. Although Keynes never officially graduated with an economics degree, he did do one term of postgraduate work with Marshall and it was Marshall that gave Keynes the job lecturing in monetary economics at Cambridge when Keynes finished his short 18-month stint as a clerk at the India Office. (See Robert Skidelsky’s fawning biography of Keynes titled “John Maynard Keynes: Economist, Philosopher, Statesmen”, page 125).

You might think that someone with such limited qualifications shouldn’t be teaching economics at Cambridge. But, as fairly noted by Skidelsky, there really wasn’t much economics to teach at that point in time. [Or at least there wasn’t much “English” economics: there was quite a bit of “German/Austrian” economics that had been written but most respectable English gentlemen in the 1930s weren’t that interested in what the Germans had to say].

For those studying economics at Oxford or Cambridge in the 1930s, there were only a small number of books that would have been considered “required reading”. One of those books was Alfred Marshall’s “Principles of Economics”.

Marshall’s “Principles of Economics” is an important book in the history of economics because that book, more than any other, was instrumental in popularizing the supply and demand diagram that we use today. Marshall’s supply and demand diagram, with “price” on the y-axis, remains one of the most fundamental concepts in economics today and Keynes would have been well versed in this theory.

The problem is that the modern-day interpretation of Marshall’s work presents a very one-sided view of the price determination process. Marshall appreciated that his representation of price determination, the standard supply and demand diagram that we use today, implicitly assumes a constant or uniform value for money.

In Chapter III.IV.17-19, Marshall discusses the issues with his derivation of the standard demand curve: “So far we have taken no account of the difficulties in getting an exact list of demand prices… To begin with, the purchasing power of money is constantly changing, and rendering necessary a correction of the results obtained on our assumption that money retains a uniform value” (my emphasis added in italics).

At least superficially, Marshall seemed to appreciate that the standard supply and demand diagram that we use today assumes a constant market value for money. However, a naïve view of Marshall “scissors analysis” is that the price of a good is determined solely by supply and demand for that good.

The naïve view of Marshall’s work leaves open an obvious question: if supply and demand for a good determines the price of a good, then what does supply and demand for money determine?

For Keynes, the most obvious answer to this question was “supply and demand for money determines the interest rate”. It’s the obvious answer and it is wrong.

The problem is that Keynes has implicitly assumed that a price is determined by only one set of supply and demand. For instance, if supply and demand for apples determines the price of apples, then supply and demand for money must determine something else.

The problem with this theory is that it does not recognize the notion, as implicitly acknowledged by Marshall, that every price depends on not only the market value of the good in question, but also the market value of money.

Unfortunately, Marshall failed to take his work one step further. Namely, if price is a relative expression of the market value and market value is determined by supply and demand, then every price must be determined by two sets of supply and demand.

Keynes never entertained the notion that price is determined by not one, but two sets of supply and demand. Therefore, he never considered the idea that supply and demand for money determines the market value of money, which, in turn, is the denominator of every money price in the economy.

The view of The Money Enigma is that the “money price” of a good (the price of a good in money terms) is a function of both supply and demand for the good itself and supply and demand for the monetary base. This concept is illustrated in the slide opposite.

The key to this diagram, as we will discuss in a moment, is the y-axis unit of measurement. “Market value” on the y-axis is measured in absolute terms, using a “standard unit” for the measurement of market value.

Every Price is Determined by Two Sets of Supply and Demand

As young economists, we are all taught the price of a good is determined by supply and demand for that good. So, how is it possible for a price to be determined by two sets of supply and demand? This is a good question and one that we have discussed in several previous posts including “A New Economic Theory of Price Determination”, “Every Price is a Function of Two Sets of Supply and Demand” and “Is the Price of Apples Determined by Supply and Demand for Bananas?”

I find that the easiest way to explain this theory is to use a simple example.

Consider the following question: “In a barter economy, what determines the price of apples, where the price of apples is measured in terms of bananas?”

Is it (a) supply and demand for apples, or (b) supply and demand for bananas?

The answer is (c), “both”.

Clearly, the price of apples, in banana terms, depends upon supply and demand for apples: if there is a supply shortage of apples, then the market value of apples will rise and the price of apples, as measured in banana terms, will rise.

But what about supply and demand for bananas? Does supply and demand for bananas have any impact on the price of apples as measured in banana terms?

The short answer is “yes”. Imagine you live in that barter economy and then think about what happens if there is a supply shortage of bananas.

If there is a supply shortage of bananas, then bananas become “more valuable”. If you have bananas and bananas become more valuable, then you would expect more apples for every banana that you sell.

The ratio of exchange, apples for bananas, will shift such that there are more apples required for one banana. One way to say this is that the price of bananas, in apple terms, would rise. The other way to say this is that the price of apples, in banana terms, would fall. A decrease in banana supply will, all else remaining, lead to a fall in the price of apples, where that price is measured in banana terms.

The general principle is illustrated in the slide opposite. The market value of the “primary good”, denoted as “V(A)”, is determined by supply and demand for the primary good. The market value of the “measurement good”, denoted as “V(B)”, is determined by supply and demand for the measurement good. The price of the primary good, in terms of a measurement good, is determined by the market value of the primary good relative to the market value of the measurement good.

What Keynes missed is that this principle also applies to the determination of “money prices”. The price of a good, in money terms, depends upon both the market value of the good (as determined by supply and demand for that good) and the market value of money (as determined by supply and demand for money).

On the left hand side, supply and demand for the good determines the market value of the good. On the right hand side, supply and demand for the monetary base determines the market value of money. The price of the good, in money terms, depends upon the numerator (the market value of the good) and the denominator (the market value of money). If the market value of money falls, then, all else remaining equal, the price of a good, in money terms, will rise.

First time readers may have trouble interpreting some of these diagrams. The key to appreciating these diagrams is getting your head around the y-axis unit of measurement.

Traditional supply and demand diagrams use price on the y-axis: “price” is a relative measure of market value. The diagrams above use a “standard unit” for the measurement of market value: in this sense, supply and demand in the diagrams above are plotted in terms of “absolute market value”.

This is a complex subject that is addressed in detail in “The Measurement of Market Value: Absolute, Relative and Real”. Please read this post if you really care about this subject.

Conclusion

So, where did Keynes go wrong?

The short answer is that Keynes assumed that a price is determined by only one set of supply and demand.

By assuming that supply and demand for money can have no direct role in the determination of “money prices”, Keynes was forced to look for something that supply and demand for money could determine. The obvious candidate may seem to be “the interest rate”, but this doesn’t make it right.

The view of The Money Enigma is that every price is a function of two sets of supply and demand. The price of a good in money terms is a relative expression of both the market value of the good and the market value of money. Therefore, the price of a good in money terms is determined by two sets of supply and demand: supply and demand for the good and supply and demand for money.

Supply and demand for money determines the market value of money, the denominator of every money price in the economy.

Interest Rate Manipulation and the Illusion of Prosperity

It is nearly nine years since the Federal Reserve last increased interest rates. During that time, the Fed has embarked on an extraordinary program of interest rate manipulation, otherwise known as quantitative easing.

Partly as a result of these actions, the US economy has continued to grow, albeit at rates below the historical average, and today most commentators believe that the long-term economic prospects of the United States are strong.

But has the aggressive manipulation of interest rates over the past couple of decades masked a structural growth problem in the United States and other Western nations? Has the Fed created an illusion of prosperity, an illusion that in and of itself has been sufficient to maintain inflation at very low levels, or at least for the time being?

There is a popular view amongst economists that suppression of interest rates is fine as long as it doesn’t lead to the economy “overheating”. In their view, serious levels of high inflation can only return if the Fed let’s the economy grow too fast. But is this quintessentially Keynesian view accurate in theory and practice? Is the greatest risk to inflation an “overheating economy”?

The view of The Money Enigma is that this Keynesian view of inflation is flawed. Rather, the primary driver of inflation is a decline in the market value of money, the denominator of every money price in the economy. In turn, the market value of money depends upon confidence in the economic prospects of society: as long-term economic confidence declines, the value of money declines and prices rise.

Currently, confidence in the long-term economic future of the United States is strong. But is that a fair reflection of reality? Has that perception been skewed by the extraordinary actions of the monetary authorities?

The view of The Money Enigma is that the suppression of interest rates over the past twenty years has created an illusion of prosperity. Low interest rate policy has pushed out both aggregate demand and supply functions, driving real output growth and keeping the market value of goods in check.

Moreover, the illusion has propped up the market value of money. In effect, growth has been pulled forward and this perceived “economic success” has reinforced confidence in the value of money, thereby keeping a lid on prices as expressed in money terms.

But what happens when interest rates rise? What happens as economic growth continues to serially disappoint? What happens if our current economic prosperity turns out to be an illusion?

Overview

Why does the Federal Reserve bother to cut interest rates when it perceives the economy as being weak? And why does cutting interest rates seem to have such a powerful effect on economic activity, at least historically?

Lowering interest rates, particularly long-term interest rates through programs such as quantitative easing, impacts the economy in two basic ways:

Increases Aggregate Demand: Lowering interest rates reduces the cost of borrowing. A lower cost of borrowing allows more consumers to borrow money and “pull forward” consumption. A lower cost of borrowing also encourages firms to borrow and invest. In this way, lowering interest rates stimulates what economists call aggregate demand and this increase in aggregate demand works to increase output and raise prices.
Increases Aggregate Supply: Less well acknowledged is the impact of lower interest rates on aggregate supply. When interest rates are lowered, particularly long-term interest rates, this reduces the cost of capital for all businesses in the economy. A lower cost of capital encourages more business to invest and, at the margin, encourages new business creation. These actions lead to an increase in aggregate supply and this increase in supply works to increase output and reduce prices.

As you can see, both the increase in aggregate demand and the increase in aggregate supply have the same impact on output: they both lead to an increase in output as demand is pulled forward and as firms are encouraged to invest. In this sense, lowering interest rates has a “double whammy” effect on economic activity, stimulating both demand and supply.

However, these two phenomena have different effects on the price level. An increase in aggregate demand will tend to raise prices, while an increase in aggregate supply will tend to reduce prices. In this way, the inflationary impact of an increase in demand is largely or completely offset by the deflationary impact of an increase in supply.

Surely, this is a recipe for economic nirvana?

Here is a policy that seems to lead to faster growth and no inflation. Indeed, the experience of the last twenty years seems to confirm the benefits of interest rate suppression. Over this period, the United States has generally experienced modest-solid growth while inflation has remained contained.

So, what is the catch?

The problem exists behind the scenes. While there are a couple of different methods the Fed can use to suppress interest rates, the main method the Fed uses to suppress interest rates (particularly, long-term interest rates) is creating money and using this money to buy government debt (in Fed speak this is called “Open Market Operations”).

Over the past seven years, we have seen an extraordinary demonstration of this policy in action: the Fed has created roughly $4 trillion in new money and used this money to buy predominantly longer-term government debt securities. Not surprisingly, this flurry of buying has pushed up the price of government debt, thereby lowering the interest rate on government debt.

So, what is the problem with creating lots of money?

Ultimately, the problem with creating money at pace faster than the growth in economic output is that it leads to a fall in the value of money and a general rise in the money price of all goods.

In the short term, a significant increase in the monetary base may have little to no impact on the value of money and the general price level, particularly if that increase in the monetary base is regarded as “temporary”. However, in the long term, an increase in the monetary base that dramatically exceeds output growth will create inflation.

The view of The Money Enigma is that the market believes that the current expansion in the monetary base is “temporary”. A temporary expansion in the monetary base should have little impact on the value of money because money is a long-duration asset.

However, should the market start to suspect that the current high levels of base money are more “permanent” in nature, then this could easily induce a fall in the value of money and a sharp rise in prices.

In essence, the Fed has backed itself into a corner.

If the Fed begins to unwind the monetary base and raise long-term interest rates, then all of the positive impacts associated with lowering interest rates will be unwound: consumption will fall, investment will fall and economic growth will stall if not go into reverse.

However, if the Fed does not reduce the monetary base, then the value of money will fall and inflation will return.

A return to high-single digit levels of inflation would create a series of poor outcomes for markets and the economy more generally. Moreover, a return to this type of inflation would force the Fed’s hand, potentially leading to a significant fall in real GDP.

A Theoretical View: Ratio Theory and the Goods-Money Framework

So far we have touched on several important theoretical concepts that I would like to discuss in more detail.

Over the past few months, we have talked a lot about a new microeconomic theory of price determination “Every Price is a Function of Two Sets of Supply and Demand” and its application to certain markets “Is the Price of Apples Determined by Supply and Demand for Bananas?”

This week, I want to extend this microeconomic theory of price determination to a macroeconomic level. More specifically, we will introduce a macroeconomic model of price level determination called “The Goods-Money Framework”.

The Goods-Money Framework, illustrated in the slide immediately below, can be used to examine the impact of interest rate suppression on real output and the price level. Moreover, it can be used to demonstrate concepts that standard Keynesian or Monetarist models struggle to accommodate.

In simple terms, the Goods-Money Framework implies that the price level (“p“) depends upon both aggregate supply and demand for goods/services and supply and demand for money.

Aggregate supply and demand for goods determines, in the first instance, the market value of goods (“VG“), the numerator of the price level. Conversely, supply and demand for money determines the market value of money (“VM“), the denominator of the price level.

The price level, the price of a basket of goods in money terms, is a relative measure that measures the market value of goods in terms of the market value of money.

The key concept behind Ratio Theory is that every price is a relative expression of the market value of the two goods being exchanged. Therefore, the price level is a relative measurement of the market value of goods V_G in terms of the market value of money V_M.

At a microeconomic level, the price of a primary good, in terms of a measurement good, is merely an expression of the market value of the primary good relative to the market value of the measurement good.

For example, if one apple (the primary good) is three times more valuable than one dollar (the measurement good), then the price of an apple, in dollar terms, is three dollars.

In order to state this concept mathematically, we need to recognize that market value can be measured in both absolute and relative terms. This is an issue that was discussed at length in “The Measurement of Market Value: Absolute, Relative and Real” (published 04/21/15).

In simple terms, in order to measure something in absolute terms, all we require is a “standard unit” for the measurement of that property. If we adopt a standard unit for the measurement of market value, then we can measure the market value of two goods (A and B) in terms of this standard unit. If the market value of good A as measured in terms of the standard unit is denoted as V_A and the market value of good B as measured in terms of the standard unit is denoted as V_B , then the price of good A, in good B terms, is the ratio of V_A divided by V_B.

If we extend this microeconomic principle to a macroeconomic level, then we can say that the price of the basket of goods (the general price level) is a ratio of (a) the market value of the basket of goods, as measured in terms of the standard unit, divided by (b) the market value of money, as measured in terms of the standard unit.

This principle is reflected in the slide below and is called the “Ratio Theory of the Price Level”. In simple terms, if the market value of the basket of goods V_G falls, then the price level p will fall. Conversely, if the market value of money V_M falls, then the price level p will rise.

If the price level is determined by the ratio of (a) the market value of goods, and (b) then market value of money, then the next obvious question to ask is what determines each of these two factors.

The view of The Money Enigma is that the market value of goods is determined by the intersection of aggregate demand and aggregate supply, as demonstrated on the left hand side of the slide immediately below. Furthermore, the market value of money is determined by the intersection of supply and demand for the monetary base as illustrated on the right hand side of the slide below.

We can now use this framework to think about what might happen when the Federal Reserve suppresses interest rates by increasing the monetary base.

As discussed in the first section of this post, the view of The Money Enigma is that lowering interest rates pushes both the aggregate demand and aggregate supply functions to the right. The net effect is a dramatic increase in real output, but very little change in the market value of goods as measured in terms of the standard unit.

The more complicated issue is what impact does the increase in base money have the market value of money?

If we take the diagram above at face value, then an increase in the monetary base should lead to a fall in the market value of money and a commensurate rise in the price level (remember: the market value of money is the denominator of the price level).

But in the short term, this may not be the case.

The reason for this is that money is a long-duration claim on the future output of society. The value of money depends not just on the current levels of real output and the monetary base, but also on expectations regarding the long-term future path of both real output and the monetary base. An increase in money supply may be accompanied by an increase in money demand if the increase in money supply is viewed as being “temporary”.

This is a complicated issue that has been discussed in several recent posts including “Money as the Equity of Society” and “What Factors Influence the Value of Fiat Money?”

The view of The Money Enigma is that the suppression of interest rates can create a growth illusion that bolsters confidence in the long-term economic prospects of society, thereby supporting the value of money, even in the face of a dramatic expansion in the monetary base.

However, if confidence in the long-term economic prospects of a society begins to falter, or if market participants start to believe that a temporary expansion in the monetary base is actually more permanent in nature, then the market value of money can quickly erode leading to a rapid rise in prices.

In summary, the manipulation of interest rates can create an illusion of prosperity. In the short term, there is no doubt that lower interest rates bolster growth. This higher level of growth fuels confidence in the long-term economic prospects of society that, in turn, supports the value of money and keeps a lid on prices. However, should this confidence begin to fade, then the market value of money can quickly erode, shattering the dream that we have created.

Is the Price of Apples Determined by Supply and Demand for Bananas?

Imagine that we live in a barter economy. What determines the price of apples in banana terms? Does the price of apples, in banana terms, depend upon (a) supply and demand for apples or (b) supply and demand for bananas?

The correct answer is (c), “both”. The price of apples, in banana terms, depends upon both supply and demand for apples and supply and demand for bananas. In this week’s post, we will explain why this is the case and we will outline a novel method for illustrating this phenomenon.

In last week’s post, “The Matrix of Prices in a Barter Economy”, we examined the theory that every price is a relative measurement of market value and explored the implications of this for price determination in a barter economy. In this week’s post, we will extend this concept and use a couple of simple examples to illustrate the principle that every price in a barter economy is a function of two sets of supply and demand.

Intuitively, the notion that the price of apples in banana terms depends upon supply and demand for both apples and bananas is not that difficult: the ratio of exchange “apples for bananas” must be determined by market forces for both of the goods being exchange. The real trick with this theory of price determination is illustrating the concept that every price is a function of two sets of supply and demand.

In order to illustrate the theory that every price is a function of two sets of supply and demand, we need to appreciate the difference between the relative measurement of a property and the absolute measurement of a property. More specifically, we need to introduce a “standard unit”, or “invariable” unit, of measurement for the property of market value. By adopting such a “standard unit” we can show, by example, how the price of one good, in terms of another, will react to changes in supply and/or demand for either of the goods.

Two Questions, One Answer

Let’s begin by contemplating two questions that relate to price determination in a barter economy.

Question One: What determines the price of apples, as measured in banana terms, in a barter economy?

At first glance, most students of economics will think that this is a very simple question. The vast majority of economics students would probably offer an answer along these lines: “The price of a good is determined by supply and demand for that good. Therefore, the price of apples is determined by supply and demand for apples.”

OK, let’s stick with that answer for a moment. Now, let’s ask our second question.

Question Two: What determines the price of bananas, as measured in apple terms, in a barter economy?

Once again, the most common answer to this question would be: “The price of a good is determined by supply and demand for that good. Therefore, the price of bananas is determined by supply and demand for bananas.”

At first sight, these might seem like reasonable answers to both of these questions. But if we dig a little deeper, we can see that a problem exists.

Let’s step back and think about the concept of “price”.

What exactly is the “price of apples in banana terms”? The price of apples in banana terms is merely a way of expressing the ratio of two quantities exchanged: a quantity of bananas for a quantity of apples. In essence, it is the number of bananas that must be exchanged for one apple in order for an exchange to occur in the current market environment. For example, the price of apples might be two bananas (if I want to buy an apple from you, I need to give you two bananas).

Now, let’s look at the other side of the picture. What is the “price of bananas in apple terms”? Once again, it is a ratio of exchange, “apples for bananas”. Indeed, it is exactly the same ratio of exchange but simply stated in different terms.

For example, if the price of apples is two bananas, then the price of bananas, in apple terms, is half an apple. Both described the same ratio of exchange: “two bananas for one apple” is exactly the same as saying “half an apple for one banana”.

In more technical terms, the price of apples in banana terms is simply the reciprocal of the price of bananas in apple terms. Both are merely different ways of stating the same “ratio of exchange” between apples and bananas.

Let’s return to the first question: “what determines the price of apples in banana terms?”

Is it correct to say that the price of apples, in banana terms, is determined solely by supply and demand for apples?

No. The market forces that determine the price of apples in banana terms must be the same as the set of market forces that determine the price of bananas in apple terms. Why? These two “different” prices are merely different ways of describing the same ratio of exchange.

So, how do we reconcile the notion that the price of apples, in banana terms, has something to with supply and demand for apples, while the price of bananas, in apple terms, has something to do with supply and demand for bananas?

There is a simple solution.

The price of apples in banana terms depends upon both supply and demand for apples and supply and demand for bananas. Similarly, the price of bananas in apple terms depends upon both supply and demand for bananas and supply and demand for apples.

In this way, the one ratio of exchange (apples for bananas) is determined by the same set of market forces (supply and demand for both goods). It doesn’t matter whether we state the ratio of exchange in apple terms or banana terms. The fact is that the ratio of exchange is determined by two sets of supply and demand: supply and demand for apples, and supply and demand for bananas.

Illustrating Supply and Demand in a Barter Economy

It is easier to understand the notion that price is determined by two sets of supply and demand if we illustrate the general concept and then perform a couple of simple examples. The general principle is illustrated in the slide below.

In simple terms, we can say:

Supply and demand for apples determines the market value of apples;
Supply and demand for bananas determines the market value of bananas;
The price of apples, in banana terms, is the determined by the ratio of the two market values (the market value of apples divided by the market value of bananas);
Therefore, the price of apples, in banana terms, is determined by both supply and demand for apples and supply and demand for bananas;
[While it is not explicitly illustrated above, we can also say that the price of bananas, in apple terms, is determined by the ratio of the two market values (the market value of bananas divided by the market value of apples) and consequently by both supply and demand for apples and supply and demand for bananas.]

All else remaining equal, if the market value of apples V(A) rises, then the price of apples, in banana terms, will rise. Conversely, if the market value of bananas V(B) rises, the price of apples, in banana terms, will fall. (If bananas become more valuable, then you need fewer bananas to acquire the same number of apples).

This concept will become clearer as we explain it by use of example. But before we do, let’s quickly think about how it is possible to represent price as a function of two sets of supply and demand.

The key is the unit of measurement used on the y-axis. More specifically, the diagram above measures market value on the y-axis in “absolute terms”, that is to say, in terms of a “standard” or “invariable” unit of market value.

In nearly every supply and demand diagram, the y-axis unit of measurement is “price”. Price is a relative measure of market value: a price measures the market value of a primary good in terms of the market value of a measurement good.

If it is possible to measure a property on a relative basis, then it is also possible to the measure that same property on an absolute basis: if we can measure the property market value on a relative basis (as a “price”), then we can also measure the property of market value on an absolute basis.

What does it mean to measure something in the “absolute”?

This is a long subject that was addressed in detail in a recent post titled “The Measurement of Market Value: Absolute, Relative and Real”.

In simple terms, a measurement is considered to be “absolute” if we measure something compared to a “standard unit” of measurement. This begs the question, what is a “standard unit” of measurement?

In order for something to act as a standard unit of measurement it must possess two properties. First, it must possess the property that is being measured. Second, it must be invariable in the property that is being measured. (For example, “inches” are a standard unit for the measurement of length).

In the slide above, we assume that there is a “standard unit” for the measurement of market value. Once we have adopted this standard unit, we can illustrate supply and demand for apples in terms of this standard unit. As the market value of apples rises, the quantity of apples demanded falls and the quantity of apples supplied rises. The “equilibrium market value” of apples, V(A), is determined by the intersection of supply and demand for apples.

Similarly, on the right hand side of our slide, we can illustrate supply and demand for bananas in terms of this standard unit. As the market value of bananas rises, the quantity of bananas demand falls and the quantity of bananas supplied rises. The “equilibrium market value” of bananas, V(B), is determined by the intersection of supply and demand for bananas.

The Price of Apples in Banana Terms

Once we have illustrated supply and demand for both apples and bananas in terms of our standard unit for the measurement of market value, we can assemble a clearer picture regarding how the price of apples in banana terms is determined (or conversely, the price of bananas in apple terms).

We discussed the basic concept of “price” in a couple of recent posts, “The Matrix of Prices in a Barter Economy” and “A New Economic Theory of Price Determination”.

In essence, every “price” is nothing more than a relative measurement of market value. The price of one good (“the primary good”) in terms of another good (“the measurement good”) is determined by the market value of the primary good relative to the market value of the measurement good.

For example, suppose that I told you that one apple was twice as valuable as one banana. Question: what is the price of apples in terms of bananas?

If one apple is twice as valuable as one banana (in a “market value” sense), then someone must offer two bananas to purchase one apple. Therefore, the price of apples, in banana terms, is two bananas.

The price of the primary good (apples) in terms of the measurement good (bananas) is determined by the relative market value of the two goods. In this case, the market value of the primary good (apples) is twice that of the market value of the measurement good (bananas). Therefore, the price of the primary good (apples), in terms of the measurement good (bananas), is two units of the measurement good (bananas).

Mathematically, we can illustrate this as shown in the slide below. If we assume that V(A) is the market value of apples as measured in terms of our “standard unit” of market value, and V(B) is the market value of bananas as measured in terms of that same standard unit, then the price of apples in banana terms, P(A_B), is merely the ratio of V(A) divided by V(B).

Now, let’s return to our earlier supply and demand diagram. Supply and demand for apples determines the market value of apples. Supply and demand for bananas determines the market value of bananas. The price of apples, in banana terms, is simply the ratio of the market value of apples divided by the market value of bananas.

Two Simple Examples

The theory that every price is a function of two sets of supply and demand is more easily explained by way of example. In this final section, let’s consider two scenarios and the impact of each on the price of apples, in banana terms, in our barter economy

Scenario One: what happens to the price of apples, in banana terms, if there is an increase in demand for apples?

If there is an increase in the demand for apples, then the demand curve for apples moves to the right. The market value of apples rises from V(A)₀ to V(A)₁. Furthermore, the price of apples, in banana terms, rises. In simple terms, if apples become more valuable relative to bananas, then the price of apples, in terms of bananas, will rise. (It will require more bananas to purchase the same amount of apples).

In the slide above, supply and demand in the apple market is measured in terms of our standard unit (in terms of “units of economic value” or “EV terms”). However, we can illustrate the market for apples in both “standard unit” terms (in terms of the absolute market value of apples) and in “price” terms (in terms of the relative market value of apples). In this example, we can see that we end up with the same type of result, no matter what unit of measurement we use on the y-axis: the demand curve for apples moves to the right as measured in both absolute and relative market value terms.

So far, so good: but what happens if there is a change in the banana market? How does a change in the banana market impact the price of apples?

Scenario Two: what happens to the price of apples, in banana terms, if there is an increase in demand for bananas?

If there is an increase in the demand for bananas, then the demand curve for bananas moves to the right. The market value of bananas rises from V(B)₀ to V(B)₁. Bananas are, to put it simply, “more valuable”.

Now, what happens to the price of apples where the price of apples is expressed in banana terms?

If there is no change in market value of an apple, V(A) is constant, then the price of apples, in banana terms, must fall. In simple terms, if apples become less valuable relative to bananas, then the price of apples, in terms of bananas, will fall. (It will require fewer bananas to purchase the same amount of apples because bananas are now “more valuable”).

Traditional supply and demand analysis (with “price” on the y-axis) struggles with this scenario. If there is “no change” in the market for apples, then how is possible for the price of apples to fall?

The answer to this question is illustrated below. Although there is no change in the absolute market value of apples, the relative market value of apples falls (the market value of apples relative to the market value of bananas falls). If apple prices are expressed in banana terms, then a rise in the market value of bananas will have the effect of shifting down both the supply curve for apples and the demand curve for apples.

The fact is that while there has been “no change” in the market for apples when measured in terms of a “standard” or “invariable” unit of market value, there has been a significant change in the market for apples when measured in terms of bananas.

One Final Word

The view of The Money Enigma is that every price is a function of two sets of supply and demand. The model we have discussed above applies not only to the determination of barter prices (“good/good prices”), but also applies to the determination of money prices (“good/money prices”) and foreign exchange rates (“money/money prices”).

Consider this point. What happens if instead of using bananas to buy apples in the examples above, we use money. Should the principle be any different? The answer is “no”: a good theory of price determination should be able to describe the determination of any type of price.

The view of The Money Enigma is that supply and demand for money (the monetary base) determines the market value of money. In turn, the market value of money is the denominator of every money price in the economy. As the market value of money falls, all else remaining equal, the price level rise. This view sits in direct opposition to the traditional Keynesian view that supply and demand for money determines the interest rate.

This theory is covered in more detail in the Price Determination section.

The Matrix of Prices in a Barter Economy

Prices existed before there was money. In the barter economy of our ancestors, there existed an entire matrix of different prices. For example, the price of corn could be expressed in many different ways (in terms of apples, in terms of bananas, in terms of rice etc.). Conversely, the price of other goods could be expressed in “corn terms” (for example, the price of apples could be expressed in terms of corn).

How was this vast array or matrix of prices determined? How were prices determined before money existed?

From a practical perspective, a discussion regarding how prices are determined in a barter economy may seem like a strange endeavor. After all, what could modern-day economic policy makers learn from understanding price determination in a barter economy? The answer is “a lot”.

Many commentators like to complain that there is something wrong with the fundamentals of modern economics, yet very few can clearly articulate exactly what is wrong and fewer still have any real idea regarding how one might fix the situation.

The view of The Money Enigma is that there is a problem and that we can trace that problem all the way back to microeconomic theory. More specifically, current microeconomic theories of price determination present a very “one-sided” view of the price determination process. It is this oversight more than any other that has led modern economics down the wrong path.

By examining how prices are determined in a barter economy, we can illustrate two important concepts regarding price determination. First, every price is nothing more than a relative measurement of the market value of the two items being exchanged. Second, every price is a function of not one, but two sets of supply and demand.

This week we will focus on the first point as it applies to the matrix of prices in a barter economy. Next week we will more fully explore the notion that every price is a function of two sets of supply and demand.

The Price of Corn in a Barter Economy

Let’s imagine that we live in a barter economy, an economy with no commonly accepted medium of exchange such as paper currency or gold coin. Now, what would you say to someone who asks you “what is the price of corn?”

In our modern, money-based economy this is an easy question to answer. Without thinking about it, we automatically express the price of corn in currency terms. For example, the price of one ear of corn might be three dollars, so we say “the price of corn is three dollars”.

But in a barter economy, we would have to clarify the question. After all, there isn’t one commonly accepted medium of exchange. So, when someone asks us “what is the price of corn?” we need to ask them “the price of corn in terms of what?”

For example, does this person want to know the price of corn in terms of apples, or the price of corn in terms of bananas?

In a barter economy there is a whole array or “matrix” of different prices. The price of any good can be expressed in terms of any other good. As economists, the question that should concern us is how is this matrix of prices determined?

For example, is the price of corn, in apple terms, determined by:

a). Supply and demand for corn; or

b). Supply and demand for apples; or

c). Both supply and demand for corn and supply and demand for apples?

Most students of economics will choose (a), the price of corn, in apple terms, is determined by supply and demand for corn. This response represents the very “one-sided” view of price determination that is taught today.

The correct answer is (c). The price of corn, in terms of apples, is determined by both supply and demand for corn and supply and demand for apples.

In order to understand why this is the case, we start with a simple idea: every price is a relative measurement of the market value of the two goods that are being exchanged.

This concept is best understood by way of example.

Question: In our barter economy, if one banana is twice as valuable as one apple and one ear of corn is twice as valuable as one banana, what is the price of corn in apple terms?

Answer: The price of corn, in apple terms, is four apples.

Let’s think through this. If the market value of a banana is twice that of an apple, then you would need to offer two apples to purchase one banana. In other words, the price of bananas, in apple terms, is two apples. Furthermore, if the market value of an ear of corn is twice that of a banana, then you would need to offer two bananas to purchase one ear of corn. Therefore, in order to purchase one ear of corn with apples, you would need to offer four apples.

In our simple example, we calculated three prices (the price of bananas in apple terms, the price of corn in banana terms and the price of corn in apple terms). In each case, the price of one good (the primary good) in terms of another good (the measurement good) is determined by the market value of the primary good relative to the market value of the measurement good. If the market value of the primary good is twice that of the measurement good, then you must offer two units of the measurement good in order to purchase on unit of the primary good.

The Matrix of Prices and the Measurement of Market Value

We can further illustrate this principle by creating a matrix of prices for our barter economy. In the slide below, the four goods in the economy (apples, bananas, corn and rice) are listed on the top row and first column. In the light shaded area you can see the price of each good in the top row in terms of each good in the first column. For example, the price of corn in terms of apples is four apples.

What this slide attempts to highlight is the basic principle that price is a relative measurement of market value. For example, if the market value of a banana is twice the market value of a cup of rice, then the price of bananas in rice terms is two cups of rice. Every one of the prices in the light shaded area is a relative measurement of the market value of one good (a good in the top row) in terms of the market value of another good (a good in the first column).

Moreover, if we can measure market value in relative terms, then we should also be able to measure market value in absolute terms. But what does it mean to measure a property in absolute terms?

We discussed this at length in a recent post titled “The Measurement of Market Value: Absolute, Relative and Real”. In simple terms, in order to measure a property in absolute terms, we need a “standard unit” for the measurement of that property. A “standard unit” is invariable in the property that it is used to measure (for example, inches are an invariable measure of the property of length).

In the slide above, we have arbitrarily assigned a market value of five standard units to one apple. If a banana is twice as valuable as an apple, then the market value of a banana, as measured in terms of our standard unit, is ten. These “absolute” market values are written next to the names of the various goods in our economy.

Now we can use this matrix to examine what happens if there is a change in the market value of one of the goods in our barter economy.

For example, what happens to prices in our barter economy if the market value of corn falls by 50%?

Stated in more formal terms, what happens to the matrix of prices in our barter economy if the market value of corn, as measured in terms of our standard unit, falls by 50%, assuming that the market value of all other goods, as measured in terms of the standard unit, remain constant?

The fall in the market value of corn has two repercussions on the matrix of prices: the first is obvious, but the second is not.

The first impact is on the price of corn as measured in terms of any other good in the economy. Clearly, if the market value of corn falls, while the market value of another good remains constant, then the price of corn in terms of that second good will fall. The red column in the table below highlights how the price of corn, as measured in terms of other goods, falls.

Whereas previously the price of corn in apple terms was four apples, the price of corn in apple terms is now only two apples.

The second impact on the matrix of prices is less obvious. If the market value of corn falls, then the price of every other good, as measured in corn terms, will rise. You can see this highlighted in the blue row in the table below.

The price of a banana, in corn terms, rises from half an ear of corn to one whole ear of corn. Why does this happen? There has been no change in the market value of bananas, as measured in terms of our “standard unit”, but the price of bananas rises. The reason is because price is a relative measure of market value. In this case, the price of bananas, in corn terms, reflects both the market value of bananas and the market value of corn. If the market value of corn falls, then the market value of bananas rises.

This can be stated in mathematical terms as follows. If the market value of good A in terms of our “standard unit” is denoted as V(A), and the market value of good B in terms of our “standard unit” is denoted as V(B), then the price of good A, in terms of good B, denoted as P(A_B), is the ratio of V(A) divided by V(B).

The price of good A, in terms of good B, can rise either because (1) the market value of good A rises, or (2) the market value of good B falls.

We can take this one step further. If the market value of good A is determined by supply and demand for good A, and the market value of good B is determined by supply and demand for good B, then the price of A, in B terms, is determined by both supply and demand for good A and supply and demand for good B.

We will explore this concept next week and apply it to a couple of examples of price determination in a barter economy. But before we do, it is worth asking what any of this has to do with the determination of prices in a money-based economy?

The view of The Money Enigma is that the model of price determination just described is a universal model of price determination. It is universal in the sense that it is a theory that describes how any price is determined, including a “money price” (the price of a good in money terms).

In simple terms, the price of a good, in money terms, is a relative expression of both the market value of the good itself and the market value of money. If the market value of money falls, the price of the good, in money terms, will rise. In this sense, the market value of money is the denominator of every money price in the economy. Moreover, supply and demand for money (the monetary base) determines the market value of money, not the interest rate.

This simple notion, if correct, represents a direct challenge to existing economic thinking. If you would like to explore this concept in more detail, then you should read The Inflation Enigma, the second paper in The Enigma Series. For a shorter summary, you can a recent post titled “A New Economic Theory of Price Determination”.

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