The Enigma Series represents the genesis of The Money Enigma. The Enigma Series is comprised of three presentations: The Money Enigma, The Inflation Enigma and The Velocity Enigma. You can download each of these presentations by clicking on the links below.

The Enigma Series seeks to provide a new perspective on money and inflation by challenging some of the core fundamentals upon which modern economics is built. In particular, The Enigma Series develops new theories regarding both the nature of money and price determination, and uses these foundations to create expectations-based solutions for the price level, the velocity of money and foreign exchange rates.

The Money Enigma

The first paper in the series, The Money Enigma, develops a new theory regarding the nature of fiat money. Current economic theories largely ignore the “liability nature” of money and, as a result, struggle to explain how money derives its value.

The view of The Money Enigma is that money only has value as an asset because it is a liability of society.

More specifically, fiat money represents a proportional claim on the future output of society (“Proportional Claim Theory”). Fiat money is a long-duration, special-form equity instrument issued by society and represents a proportional claim on the future output of society.

Current economic theories largely ignore the “liability nature” of money. Indeed, most theories of money focus solely on the “asset nature” of money and thereby struggle to explain how money derives its value.

This perspective on the “liability nature” of money allows us to avoid the circular logic that is deeply embedded in most theories of money demand. It is the view of The Money Enigma that money does not derive its value from the functions that it performs (e.g., medium of exchange, store of value, unit of account). Rather, money can only perform its functions because it has value as a liability of society (i.e., as a proportional claim on the output of society). Most theories of money, including Keynes’ liquidity preference theory, begin with the assumption that demand for money is derived from the functions that money performs: but money can only perform its functions because there is demand for it.

The Money Enigma concludes by challenging several aspects of Keynes’ liquidity preference theory. Most notably, the view of The Enigma Series is that supply and demand for money determines the market value of money, the denominator of every “money price” in the economy.

While creating money and using it to buy government debt will, all else remaining equal, increase the demand for government debt and lower the interest rate, supply and demand for money does not determine the interest rate. Rather, supply and demand for government debt determines the interest rate. This may seem like a subtle distinction, but it is a fundamental point and one that is explored further in the second paper in the series, The Inflation Enigma.

The Inflation Enigma

The second paper in the series, The Inflation Enigma, focuses on the nature of price determination. Current microeconomic theories of price determination provide a one-sided view of the price determination process. The view of The Inflation Enigma is that every price is a relative expression of two market values. Hence, every price can be better understood a function of two sets of supply and demand.

The key to this theory is recognising that price is a relative measure of market value. The price of one good (the “primary good”), in terms of another good (the “measurement good”) is a relative expression of the market value of the primary good in terms of the measurement good.

If we can measure market value in relative terms, then it should also be possible to measure market value in absolute terms (in terms of a “standard unit”). If we measure the market value of two goods (A and B) in terms of a standard unit (“units of economic value”), then we can illustrate that the price of A in B terms is a ratio of the market value of A divided by the market value of B.

Once we have established that price is a ratio of two market values, then we can illustrate price determination as a function of two sets of supply and demand.

Supply and demand for good A determines the equilibrium market value of good A, denoted V(A). Supply and demand for good B determines the equilibrium market value of good B, denoted V(B). The price of good A in good B terms is determined by the ratio of the two equilibrium market values. Hence, the price of good A in good B terms is determined by two sets of supply and demand.

This theory represents a universal theory of price determination. It applies to the determination of prices in a barter economy (“good/good” prices), the price of goods in money terms (“good/money” prices) and foreign exchange rates (“money/money” prices).

This microeconomic theory of price determination has important macroeconomic implications.

First, supply and demand for money (the monetary base) determines the market value of money, the denominator of every “money price” in the economy. Supply and demand for money does not determine the interest rate.

Second, the price level can be considered to be a function of two market values (“Ratio Theory of the Price Level”).

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 simple terms, the price level can rise either because (a) the market value of goods rises, or (b) the market value of money falls.

The Inflation Enigma develops a simple model to help think about price level determination called “The Goods-Money Framework”. The key implication of The Goods-Money Framework is that the price level is determined, in a stylized sense, by two sets of supply and demand: aggregate supply and demand for goods/services, and supply and demand for the monetary base.

The Velocity Enigma

The final paper in the series, The Velocity Enigma, brings together the concepts developed in the first two papers to build a valuation model for fiat money called the “Discounted Future Benefits Model for Money”. This valuation model is used to create expectations-based solutions for the price level, the velocity of money and foreign exchange rates.

If money is a financial instrument (a special-form equity instrument and proportional claim on the future output of society) and if we can measure the market value of money in terms of an invariable measure of market value (a “standard unit” of market value), then it should be possible to build a discounted future benefits model for money just as we can build a discounted future cash flow model for any other equity instrument.

Building a “valuation model” for money is a non-trivial task that requires a number of special modifications to the familiar discounted future cash flow model used to value most financial instruments. First, the model must be expressed in absolute terms (in “standard unit” terms), not “dollars”. Second, money is a claim on future output, not future cash flows. Third, money represents a claim to a slice, not a stream, of future output. Mathematically, this requires us to create a probability distribution for the expected spending of the marginal unit of money demanded. Fortunately, we can leverage the notion of intertemporal equilibrium to create this probability distribution.

The end result provides us with some unique insights into the key economic factors that impact the value of fiat money. Most importantly, the model highlights the notion that the value of money is highly dependent upon expectations regarding the long-term path of the “real output/base money” ratio. Furthermore, the market value of money is far more sensitive to changes in these long-term expectations than to any “temporary” change in the current level of the monetary base.

This model for the value of fiat money can be used to develop expectations-based solutions for the price level, the velocity of money and foreign exchange rates.

The model for the price level is displayed in the slide opposite. The model implies that the price level can be considered to be a function of a baseline component and an expectations component.

This model for the price level might help to explain why a large increase in the monetary base may have little impact on the price level if the increase in the monetary base is perceived to be a temporary event, rather than a shift to a higher, more permanent plateau.

Moreover, this model demonstrates that, the price level is ultimately a function of confidence regarding the long-term economic prospects of society.