Tag Archives: price level and expectations

Is Money a Short-Duration or Long-Duration Asset?

Is the value of money more sensitive to changes in short-term expectations or long-term expectations? Is what happens in the economy today the key driver of the value of money and the price level, or are both the value of money and the price level driven primarily by confidence about the long-term economic future of society?

In last week’s post, we explored the idea that “money is only as good as the society that issues it”. More specifically, the value of any given fiat currency depends primarily upon expectations regarding the future economic prospects of the society that issues it. But is the value of money more sensitive to expectations regarding the near-term economic prospects of society or the long-term economic prospects of society?

We can state this question another way: “Is fiat money a short-duration or long-duration asset?” This may seem like a strange question to ask about money. After all, most people associate the concept of duration with fixed income securities, not “cash” (the monetary base).

However, every financial instrument, including fiat money, can be considered to possess the property of “duration”. Moreover, the duration of an asset is a critical determinant of how that asset behaves in response to changes in expectations.

The view of The Money Enigma is that fiat money is a financial instrument and a proportional claim on the future output of society. More specifically, fiat money is a long-duration instrument.

While there are a couple of ways to demonstrate that money is a long-duration asset, the simplest method is to apply what I call the “benefits-cut-off” test, i.e. imagine if it was announced that money would be no longer accepted in exchange for goods and services in one year from now or five years from now, or twenty years from now etc. and imagine what would happen to the current value of money in each of those circumstances.

Why does the duration of money matter? Well, if we understand the duration of fiat money, then we can create better models for the value of money and, consequently, the price level. More specifically, if money is long-duration asset, then we can argue that both the value of money and the price level are far more responsive to changes in confidence regarding the long-term economic future of society than they are to any change near-term economic conditions.

The Concept of Duration

The duration of an asset is the weighted average time that it will take to receive the present value of the benefits generated by that asset. The term is most commonly applied to fixed income securities. A 5-year, interest-bearing government bond is a “short-duration” asset, while a 30-year zero-coupon bond is a “long-duration” asset.

From a practical perspective, if an asset is a “short-duration asset”, then most of its value relates to benefits that will be received in the near future. Short-duration assets are highly sensitive to changes in current conditions and expectations regarding the near future, i.e. the next 2-3 years. However, short-duration assets are, as a general rule, completely insensitive to changes in long-term expectations.

In contrast, the value of a “long-duration asset” depends primarily on benefits to be received in the distant future, i.e. 10-20 years from now. The value of a long-duration asset is highly sensitive to changes in long-term expectations, but relatively insensitive to changes in expectations regarding short-term conditions.

While the concept of duration is most commonly applied to fixed income securities, it can be applied to any financial instrument. After all, the value of every financial instrument depends upon benefits that we expect to receive from that financial instrument in the future. “Duration” simply provides with a measure of the average time taken to receive the present value of those benefits.

Indeed, every financial instrument can be considered to possess the property of “duration”. For example, John Hussman often discusses the idea that equities are a very long-duration asset. In theory, the stock market should be far more sensitive to changes in expectations regarding long-term earnings growth than changes in current economic conditions and earnings.

If every financial instrument possesses the property of duration, then this raises two interesting question relating to the nature of money. Is fiat money a financial instrument? And if it is, then what is the duration of fiat money?

Fiat Money as a Financial Instrument

The view of The Money Enigma is that fiat money is a financial instrument. Every asset can be classified as either a real asset or a financial instrument. Fiat money is not a real asset and, therefore, must be a financial instrument.

The classification of assets into real assets and financial instruments is important because it relates to how an asset derives it value. Assets can only derive their value in two ways: either they derive their value from their physical properties or they derive their value from their contractual properties.

A real asset is an asset that is tangible or physical in nature. More importantly, it is an asset that derives its value from these tangible or physical properties.

In contrast, a financial instrument is, by definition, both an asset and a liability. A financial instrument derives its value as an asset from the liability that it represents to another. In this sense, the value of a financial instrument can be considered to be an artificial creation of a contract entered into by economic agents.

In simple terms, if something doesn’t derive any value from its natural or intrinsic properties, then the only way it can derive value is if it creates an obligation on a third party to deliver something of value. Indeed, this paradigm is so fundamental that it is used as the basis of classification of assets for accounting purposes.

So, where does fiat money fit in this simple paradigm? Does fiat money derive its value from its physical nature or does it derive its value from the liability that it represents to its issuer?

The view of The Money Enigma is that fiat money is a financial instrument and derives its value solely from the nature of the liability that it represents. Money is an asset to one party because it is a liability to another. More specifically, money is a liability of society and represents a proportional claim on the future output of society.

In simple terms, the cash in your pocket has value to you today because you believe that you will be able to exchange that cash for goods and services in the future. The money in your pocket represents a claim against the future output of society. This is the essence of the social contract that fiat money represents.

So, if fiat money is a financial instrument and every financial instrument possesses the property of duration, then what is the duration of fiat money?

The Duration of Fiat Money

One of the aspects of fiat money that makes it rather unique as a financial instrument is that it doesn’t entitle us to a stream of future benefits. Rather, it entitles us to a slice of future benefits. In simple terms, we can only spend the dollar in our pocket once. We can spend it today, tomorrow, one year from now or twenty years from now.

Since most of us are in the habit of spending the dollars in our pocket within a week or two, this would suggest that money is a short-duration asset. However, this simplistic form of analysis is wrong. Just because we don’t typically hold the same cash in our pockets for a long period of time, doesn’t mean that fiat money is a short-duration asset.

There are two much better ways to think about the duration of money. The first is relatively simple and involves the application of a basic test. The second is more complex and requires an appreciation of the economic concept of “intertemporal equilibrium”.

Let’s begin by discussing the first, relatively simple approach.

There is an easy test for duration of any asset. For lack of a better term, we can call this test the “benefits cut-off test”.

As discussed, a financial instrument only has value because it creates an obligation on the issuer of that instrument to deliver something of value in the future.

The benefits cut-off test involves imagining a scenario in which the issuer of that financial instrument announces that it will not to honor the liability starting x years from now and thinking about the impact that announcement would have on the current value of the security.

For example, if the government announced that, starting five years from today, it would stop paying interest and principal on all government debt, what would be the impact on the value of its debt?

Clearly, it depends on the duration of the debt. The announcement should have no impact on one-year government debt, after all, the interest and principal will be repaid well before the government stops honoring its commitments.

But what about recently issued 30-year debt? Clearly, the value of such debt would collapse. Why? Because it is a long-duration asset: most of its value is associated with payments that will be made well beyond five years from now.

Now, let’s apply the benefits cut-off test to fiat money.

As mentioned, the view of The Money Enigma is that money is a financial instrument that represents a proportional claim on the output of society. In short, fiat money is a liability of society and its value depends on society honoring its obligation to deliver output in exchange for little pieces of paper.

Now, what would happen to the value of money and, conversely, the price level, if it were announced that society would not honor money’s claim on output starting one year from now?

Think about this for a moment. What would your immediate reaction be if the government announced that cash would no longer be accepted in commercial exchange one year from now? My guess is that you would try get rid of all your cash and cash-related securities, i.e. bank deposits, as fast as possible!

The problem is that everyone else would try to do the same thing. What would happen to the value of money if everyone wants to get rid of it and no one wants to accept it? It would collapse.

If the government announced that money would no longer be accepted one year from now, then it seems reasonable to believe that there would be panic and the value of money would collapse, not in one year, but today, right now. What would happen to prices in this scenario? Prices would soar. You can imagine the scene: people offering $100,000 for a jar of peanut butter and the grocer refusing to accept it.

Let’s try a different scenario. What if it was announced that the cut off was 5 years from now? In other words, what would be the reaction if everyone learnt that money would not be recognized as a claim on output starting five years from now?

In this scenario, there might not be panic, but there probably would be an immediate drop of in the demand for money. Again, money would lose a substantial portion of its value very quickly and prices, as expressed in money terms, would skyrocket.

What about if the cut off was 10 years from now? Maybe a smaller drop in value, but still a drop in value.

Now, apply a 30-year test. Would there be a significant drop in the value of money today? Probably not. Why? Well, 30 years is a long time from now. Arguably, money could function for at least another ten years before people really start to worry about the end point.

Clearly, this exercise involves a large degree of speculation, so we won’t belabor the point. Nevertheless, it does give some credence to the view that money is a long-duration asset. The value of money is highly dependent upon the expectation of benefits, in the form of goods and services, that can be claimed with money not just months but years from now.

So, how is it possible for money to be a long-duration asset? After all, we tend to think of money as something that we can spend now or at any time we wish.

The benefits cut-off test provides a hint as to the answer: the value of money today depends upon a long chain of expected future values.

In very simple terms, I accept money from you because I think I will be able to acquire goods of value from the next person. In turn, the person who accepts that money from me does so because they think that the next person will accept it as something of value. And so a chain develops: money has value now because we believe it will have value to each successive person in the chain.

Fiat Money and Intertemporal Equilibrium

What our very basic example highlights is that the equilibrium value of money incorporates a chain of expected future values for money. More specifically, the present value of money depends largely upon the expected variable entitlement of money in distant future periods. If, as in our example, the entitlement of money drops to zero in future periods, then this has a big impact on the current equilibrium value of money.

In theory, the economy should always be in or adjusting towards a state of intertemporal equilibrium. If it is announced that society will no longer recognize money as a claim on output beginning next year, then it will lose all, or nearly all, of its value today. In essence, a state of intertemporal equilibrium is disrupted by the announcement: everyone tries to spend the money today with the result that no one can spend the money, or only at a massively reduced value.

In our simple one-year cut-off example, equilibrium is only restored once the value of money has fallen to such a degree that someone is prepared to accept it in exchange for goods or services. The price level may well have to rise by a 1000% or more in order to restore a state of intertemporal equilibrium.

Interestingly, there is another way we can leverage the concept of intertemporal equilibrium to demonstrate that fiat money is a long-duration asset. More specifically, we can use the concept of intertemporal equilibrium to demonstrate that the expected value of money in distant future periods does impact the value that we put on money today.

This process starts by investigating one of the key differences between fiat money and shares of common stock.

One of the most obvious differences between money and a traditional equity instrument is that one unit of money provides its holder with a claim to a slice, not a stream, of future economic benefits. A share of common stock provides its holder with a proportional claim to a stream of future cash flows. In contrast, one unit of money provides its holder with a one-time claim on the output of society, or a “slice” of future output.

If a financial instrument entitles its holder to a stream of future benefits, then we can create a valuation model for that asset by simply adding the present value of each of the expected future benefits in that stream.

However, if a financial instrument entitles its holder to a slice of some set of possible future benefits, then we face a different challenge: the present value of that instrument could equal one future benefit or another or another.

In essence, we are left with a question of probability: what is the probability that the holder of that financial instrument will claim any one of n different future benefits? If we know the probability of each slice being claimed (i.e. the probability of when the money will be spent), then we can calculate the present value of the asset.

So, how do we create a probability function to weight each of the possible future values of money and, thereby, determine the current equilibrium value of money? The key to the answer lies in the question itself: the concept of “equilibrium”.

Equilibrium can be thought of in one period terms, “static equilibrium”, or in multi-period terms, “intertemporal equilibrium”. It is the view of The Enigma Series that in order for the economy to be in a state of intertemporal equilibrium, the marginal holder of money must be indifferent between spending the marginal unit of money at any point in their future-spending horizon.

Think about it this way: if you would much prefer to spend the marginal dollar you receive in five years, than spend it today, then you haven’t maximized your utility and the economy is not in a state of equilibrium. In simple terms, you have an incentive to act and, by definition, the economy is not a “state of rest”.

If you have n years remaining in your life, then technically, for the economy to be a state of general equilibrium, you should be indifferent between spending money now versus spending money in any one of those future n years. Moreover, you will also be indifferent as to which of those future periods you spend the money in. For example, you will be indifferent as to whether you spend the marginal dollar in 5 years, 10 years or 20 years.

[Geeks note: Mathematically, if you are indifferent between A (spending money now) and B (spending money in 5 years) and indifferent between A (now) and C (10 years), then you are also indifferent between B (5 years) and C (10 years)].

Now, we can use this idea to create our probability distribution. If the marginal holder of money must be indifferent between spending the marginal unit of money at any point in the future n period spending horizon, then the probability that the marginal unit of money is spent in any one of the future n periods is 1/n.

At least theoretically, the probability that we spend the marginal dollar twenty years from now is the same as the probability that we spend it one year from now. Therefore, the value we put on money today will incorporate not only expectations about the value of money one year from now, but the value of money thirty or even forty years from now.

This application of equilibrium theory casts new light on the duration of money. The value of money doesn’t just depend on what we expect we might get for it one or two years from now. Rather, the value of money also depends heavily on what we might expect to get for that money many years, if not decades, from now.

In summary, the value of money depends upon long-term expectations. Fiat money is a long-duration asset and the value of fiat money is highly sensitive to changes in expectations regarding the long-term (20-30 year) economic future of society.

A New Perspective on the Quantity Theory of Money

The view of The Money Enigma is that the quantity theory of money needs to be reinvented. More specifically, the traditional view of the monetary transmission mechanism is wrong and needs to be completely reexamined.

The mainstream view of the monetary transmission mechanism is, in essence, that money creation leads to excess aggregate demand that, in turn, leads to higher prices. The view of The Money Enigma is that this transmission mechanism from more money to higher prices via an increase in aggregate demand is, at best, a secondary transmission mechanism.

Rather, it will be argued that the primary monetary transmission mechanism is the impact of money creation on the market value of money. In essence, “too much money” leads directly to a fall in the value of money and a rise in the price of all goods as measured in money terms.

The “value of money” is a notion that has been lost from economic theory. Indeed, mainstream economics simply doesn’t recognize the “value of money” as an independent variable, an issue that was discussed at length in “The Value of Money: Is Economics Missing a Variable?”

In this week’s post, we will attempt to shed new light on the quantity theory of money by articulating an explicit role for the value of money in the monetary transmission mechanism.

More specifically, we will discuss the role of the value of money in price level determination and we will consider, at least briefly, a theory of money that can explain why money creation leads to a fall in the value of money on some occasions, but not on others.

While money supply and real output matter to price level determination, the view of The Money Enigma is that long-term expectations of these variables are far more important than their present level. We can only incorporate these long-term expectations into quantity theory by examining how these expectations impact the value of money and the role of the value of money in price level determination.

Hopefully, this exercise will provide readers with a new and much clearer perspective on why the quantity theory of money tends to hold over long periods of time, but not necessarily over short periods of time.

The Strengths and Weaknesses of Quantity Theory

The quantity theory of money is one of the oldest surviving economic doctrines. It is a theory that dates back to at least the mid-16^th century and it was the dominant monetary theory until the Keynesian revolution of the 1930s. A good discussion of the history of the theory can be found in a 1974 paper published by the Richmond Fed, “The Quantity Theory of Money: Its Historical Evolution and Role in Policy Debates”.

It is hard to overestimate the importance and dominance of the quantity theory of money in the history of economic thought. Yet, despite a brief resurgence of interest in the late 1960s and early 1970s, quantity theory has become the forgotten child of economics: a theory that every economist learns, but one that very few seem to regard as relevant in our modern world.

While die-hard monetarists might blame the demise of quantity theory on the rise of Keynesianism, there is a more simple truth at play: quantity theory of money, as it is traditionally presented, is flawed.

The core principle at the heart of quantity theory, the notion that there is a strong relationship between the quantity of money and the price level, is fundamental, if for no other reason than the fact that it represents one of the strongest empirical relationships to be found between major economic variables.

When measured over long periods of time, there is a clear empirical relationship between the “monetary base/real output” ratio and the price level. For this reason alone, quantity theory should always occupy a revered position in the science of economics.

However, the problems for quantity theory begin when various practitioners and market commentators attempt to apply it over short periods of time. As has been well established by recent experience, there is no strict short-term relationship between the size of the monetary base and the price level. Over the past seven years, the Fed has quintupled the size of the monetary base, yet inflation has remained subdued.

This is the point at which many commentators throw quantity theory out with the garbage. Their view seems to be that if quantity theory doesn’t work in the short run, then it is as good as useless.

This is a mistake. Quantity theory should not be abandoned just because the relationship between money and prices does not hold in the short term.

Nevertheless, the burden of proof sits with advocates of quantity theory. Supporters of quantity theory need to be able to explain why quantity theory doesn’t work in the short term. The problem is that they can’t.

Why is this the case? Well, the key issue is that current theories of the monetary transmission mechanism don’t provide supporters of quantity theory with a sound basis for defending the lack of correlation between money and prices in the short run.

The view of most monetarists today is that supply and demand for money determines the interest rate. Therefore, an increase in the supply of money must operate by lowering the interest rate. In turn, a lower interest rate must stimulate economic activity leading to an increase in aggregate demand and higher prices.

In theory this sounds great, the problem is that it doesn’t work in practice. More specifically, it doesn’t explain why an increase in the monetary base leads to an increase in prices on some occasions but not others. Moreover, this simplistic view of the monetary transmission can’t account for periods of high inflation: for example, Zimbabwe didn’t experience hyperinflation because interest rates were too low and there was “too much demand”.

The problem with monetarism as it exists today is that it begins from the wrong starting point. Far from being a true monetarist view of the world, the monetary transmission mechanism described above represents a thoroughly Keynesian view of the world.

The view of The Money Enigma is that this inherently Keynesian perspective is flawed. Supply and demand for money does not determine the interest rate. Rather, supply and demand for 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 and, consequently, the denominator of the price level.

By recognizing that the primary transmission mechanism from money to prices must involve the “value of money”, we can come up with an expectations-adjusted version of quantity theory that can explain not only why quantity theory works in the long run, but also the circumstances that are required for quantity theory to work in the short run.

Our journey towards an expectations-adjusted quantity theory of money begins at a microeconomic level. More specifically, we need to explore three ideas: (1) money possesses the property of market value, (2) every price is a relative expression of market value, and (3) the price of a good, in money terms, depends upon both the market value of the good itself and the market value of money.

Price Determination and the Value of Money

If you ask most students of economics “what determines the price of a good?” then the answer you are most likely to hear is “supply and demand for that good”. This is the way that price determination is taught across schools and colleges today. However, this basic model of price determination presents a misleading and very one-sided view of the price determination process.

The problem is that economics seems to have forgotten a simple, but easily overlooked idea, an idea that was articulated centuries ago by both Adam Smith and David Ricardo: price is a relative measure of the value of two goods.

In order for a commercial exchange of goods to occur between two people, both of the goods being exchanged must possess the property of market value. In other words, I am only going to give you something of value if you give me something of value.

In a barter economy, I might have apples and you might have bananas. The ratio of exchange, apples for bananas, will depend upon the relative market value of apples and bananas at that time. For example, if an apple is twice as valuable as a banana, then the ratio of exchange is two bananas for one apples and the “price of apples in banana terms” is “two bananas”.

The price of apples in banana terms can rise for one of two basic reasons: either (a) the value of apples rises, or (b) the value of bananas falls.

Think about this for a moment. If bananas become less valuable in our community (there is a huge crop this year), then, all else remaining equal, you will have to offer me more bananas for each apple. Therefore, the price of apples in banana terms will rise.

In a money-based economy, the principle is no different.

In order for people to accept money in exchange for goods, money must possess the property of market value. For example, I wouldn’t accept money from you in exchange for my apples, unless I believe that money itself has value.

The ratio of exchange, apples for money, depends upon the relative market value of apples and money. If an apple is twice as valuable as one dollar, then the price of apples in dollar terms is two dollars. Moreover, the price of apples in dollar terms can rise because either (a) the market value of apples rises, or (b) the market value of money falls.

Mathematically, the price of a good in money terms is a ratio of two values (see following slide). The numerator is the market value of the good itself. The denominator is the market value of money.

The key to illustrating price determination in this way is recognizing that the property of market value can be measured in both relative and absolute terms. On the right hand side of the equation above, the market value of the good and the market value of money are both isolated as independent variables by measuring the market value of each in absolute terms. This is a rather complicated idea and I would strongly recommend that you read one of my earlier posts titled “The Measurement of Market Value: Absolute, Relative and Real” in order to more fully appreciate this concept.

This basic notion (price is a relative measurement of the market value of two goods) suggests that there are, in fact, two market processes at play in the determination of any price.

For example, in the case of the price of apples in money terms, one market process is determining the market value of apples, while another, completely different process, is determining the market value of money. The price of apples, in money terms, depends upon the equilibrium point that is found in both of these distinct processes.

Put another way, we can say that every price is a function of two sets of supply and demand. The price of one good (the primary good) in terms of another good (the measurement good) is a function of both supply and demand for the primary good and supply and demand for the measurement good.

The slide above presents the general version of this theory of price determination. Supply and demand for good A, the primary good, determines the equilibrium market value of good A. Supply and demand for good B, the measurement good, determines the equilibrium market value of good B. The price of A in B terms is determined by the ratio of these two market values. Therefore, the price of A in B terms is determined by two sets of supply and demand.

In the case of a money-based economy, the measurement good most commonly used is money. Money must possess the property of market value in order for it to be used as a medium of exchange. The view of The Money Enigma is that the market value of money is determined by supply and demand for the monetary base.

If you are interested in learning more about this microeconomic theory of price determination then I would encourage you to visit the Price Determination section of this website.

For now, the key point that matters is that the price of a good in money terms depends upon both the market value of the good itself and the market value of money. The price of a good in money terms can rise because either (1) the good itself becomes more valuable, or (2) money becomes less valuable.

If this microeconomic theory of price determination is correct, then we can extend it to the determination of the price level. After all, the price level is merely a hypothetical measure of the overall price of the basket of goods.

If every price is a relative measure of market value, then the price level is also a relative measure of market value. More specifically, the price level is a relative measure of the market value of the basket of goods in terms of the market value of money.

Rethinking the Monetary Transmission Mechanism

In simple terms, the slide above implies that the price level can rise for one of two reasons: either (1) the market value of the basket of goods rises, or (2) the market value of money falls.

While this model of price level determination may seem simplistic, it does open up an important question regarding the way in which monetary policy operates. More specifically, does an expansion of the monetary base lead to a rise in prices because (a) lower interest rates drive higher aggregate demand which leads to a rise in the market value of goods, or (b) does an increase in the monetary base somehow lead to a fall in the market value of money?

In more technical terms, does an increase in the monetary base impact the numerator (“V_G”) or the denominator (“V_M”) in our price level equation? Does it impact both? And if it does impact both, then which represents the primary monetary transmission mechanism from “more money” to “higher prices”?

We will consider the reaction of the market value of money (the denominator) to an increase in the monetary base in a moment: it is a complicated subject and we need to spend quite a bit of time thinking about it. But before we do, let’s think about how the market value of the basket of goods (the numerator) might respond to an expansion of the monetary base.

In order to assist us in this process, we are going to introduce the “Goods-Money Framework” (see slide below). In essence, the Goods-Money Framework represents an adaptation of traditional aggregate supply and demand analysis. On the left-hand side of the slide below, aggregate supply and demand determine the equilibrium market value of the basket of goods. On the right-hand side, supply and demand for money determine the market value of money. As discussed, the price is determined by the ratio of these two values.

Let’s focus on the left hand side of the slide above and think about how the equilibrium market value of goods (“V_G”) is likely to respond to an expansion in the monetary base.

The traditional Keynesian view would suggest that an expansion of the monetary base leads to a fall in interest rates. In turn, a fall in interest rates leads to an increase in aggregate demand. In terms of our slide above, the aggregate demand curve shifts to the right and the market value of the basket of goods rises. Implicitly, the Keynesian view assumes that the market value of money is constant (I say “implicitly” because Keynesian theory doesn’t recognise a role for the “value of money” in price determination). Therefore, any rise in the market value of goods is reflected as a rise in the price level.

As far as the traditional Keynesian view is concerned, this is where the story ends. An increase in money supply leads to higher demand and higher prices. The problem is that this story completely ignores the impact of lower interest rates on the aggregate supply curve.

In the real world, lower long-term interest rates not only lead to an increase in aggregate demand, but also lead to an increase in aggregate supply. In terms of our slide above, a fall in interest rates moves both aggregate demand and aggregate supply curves to the right and the impact on the equilibrium market value of goods is uncertain.

Lowering the long-term interest rate on government securities does more than just reduce mortgage rates and stimulate consumer spending: it also reduces the required return on capital for all businesses. Lowering the required return on capital stimulates expansion by existing businesses and lowers the bar to the start up of new businesses. What is the end result of all this new business activity? More supply!

When the central bank lowers the long-term interest rate by creating money and buying government securities, it effectively lowers the long-term risk free rate, a core component of the long-term required rate of return on risk assets, thereby encouraging business formation and driving an increase in aggregate supply.

Therefore, if Keynesian economists were sincere about the impact of lower interest rates, they would recognize that lower interest rates lead to both an increase in aggregate demand and aggregate supply and that the impact of monetary expansion on the absolute market value of the basket of goods is uncertain.

If this is the case, the traditional monetary transmission mechanism that is postulated by mainstream macroeconomists (more money, lower interest rates, more demand) is at best a secondary mechanism, and at worst is completely irrelevant.

Clearly, this analysis has an important implication.

If the numerator in our price level equation (the market value of the basket of goods) doesn’t act as the primary transmission mechanism from more money to higher prices, then it must be the market value of money, the denominator in our price level equation, which acts as the primary monetary transmission mechanism.

But how does “more money” impact the value of money? And if monetary base expansion should lead to a fall in the market value of money, then why have we not experienced this over the past seven years?

What Determines the Value of Money?

Those of you who are familiar with The Money Enigma will know that this is a topic that has been discussed at length over the past six months. If you want to take the crash course on this topic, then I would suggest reading “The Evolution of Money: Why Does Fiat Money Have Value?” and a follow-on post titled “What Factors Influence the Value of Fiat Money?”

For the purposes of this exercise, we will briefly discuss the nature of fiat money and how the value of fiat money is determined and then we will discuss the implications of this theory for quantity theory and the monetary transmission mechanism

The view of The Money Enigma is that fiat money is a financial instrument and derives its value solely from the nature of the liability that it represents. Fiat money is an asset to one party because it is a liability to another: fiat money is, from an economic perspective, a liability of society and represents a claim on the future output of society. More specifically, fiat money is a long-duration, special-form equity instrument and a proportional claim on the future output of society.

Every asset is either a real asset or a financial instrument. Real assets derive their value from their physical properties; financial instruments derive their value from their contractual properties.

The view of The Money Enigma is that this paradigm governs the way in which every asset, including money, derives its value. In ancient times, money was a real asset: money was a commodity (such as rice or silver) that derived its value from its physical properties.

The problem with this “commodity money” is that it restricted the ability of governments to spend (you can’t spend gold you don’t have). However, at some point, governments found a way to get around this problem: issue paper notes that promise to deliver gold on request. By issuing this first form of paper money, known as “representative money”, governments could aggressively expand their spending.

This first paper money was a financial instrument. It derived its value from its contractual properties. More specifically, it represented an explicit promise to deliver a real asset on request.

Ultimately, the issuance of representative money also limited the amount of money that governments could create. Therefore, at some point the gold convertibility feature was removed. This point marks the shift from representative money to fiat money.

In effect, the explicit contract that governed representative money was rendered null and void. So why did paper money maintain any value? The view of The Money Enigma is that the explicit contract that governed representative money was replaced by an implied-in-fact contract that governs fiat money to this day.

Fiat money is not a real asset and does not derive its value from its physical properties. Therefore, prima facie, fiat money is a financial instrument and must derive its value from its contractual properties, even if that contract is implied rather than explicit.

The exact nature of the implied-in-fact contract that governs fiat money is difficult to unravel. It is an issue that is discussed at length in the “Theory of Money” section of this website. However, in simple terms, the view of The Money Enigma is that fiat money is a liability of society and represents a claim against the future output of society.

More importantly, fiat money represents a variable entitlement to future output. In this sense, fiat money can be considered to be similar to shares of common stock: fiat money is a proportional claim on the future output of society, just as a share of common stock is a proportional claim on the future cash flow of a company

While there are important differences between the two, this concept can help us think about the factors that influence the market value of money, the denominator in our price level equation.

For example, if this theory is correct, then the value of fiat money is determined primarily by expectations regarding the long-term future path of two economic variables: real output and the monetary base.

In simple terms, future real output is the cake and the size of the future monetary base represents the number of slices the cake must be cut up into. If people become more optimistic about the long-term rate of economic growth, then the market value of money rises. Conversely, if people believe that long-term monetary base growth will be higher than previously anticipated, then the market value of money will fall.

The other important implication of this theory is that expectations regarding the long-term path of money and real output are far more important than current levels of money and real output in the determination of the value of money. Money is a long-duration asset and, like all long-duration assets, its value primarily depends on long-term expectations, not current conditions.

Why does this matter to quantity theory? Well, it may just be the missing piece that explains why quantity theory works well over long periods of time, but not short periods of time.

An Expectations-Adjusted Quantity Theory of Money

Let’s start by thinking about why the quantity theory of money works over long periods of time.

If the theory of money articulated above is correct, then for any long period of time (30 years+), an increase in the monetary base that is far in excess of the increase in real output should lead to a significant fall in the market value of money and, correspondingly, a significant rise in the price level.

If money is a proportional claim on economic output and, over a long period of time, the growth in the number of claims (the monetary base) far exceeds the growth in the economic benefit (real output), then one would reasonably expect the value of each claim to fall considerably as measured from point to point over that extended period of time.

Moreover, since the price level is a relative measure of the market value of goods in terms of the market value of money, one would also reasonably expect the price level to rise considerably over that same time period, assuming there was no reason for a massive collapse in the market value of goods.

In summary, quantity theory works in the long term because the market value of money roughly tracks the ratio of “real output/base money” over the long term.

However, the quantity theory of money breaks down over short periods of time. The reason for this is that short-term variations in the value of money are primarily driven by shifts in long-term expectations.

If you take a long hard look at the equation of exchange (the core equation of quantity theory), the one thing that should strike you about it is that it allows no explicit role for expectations in the determination of the price level.

If interpreted literally, then the equation of exchange implies that the price level is a function of only three variables: the current level of real output, the current level of money supply, and the current level of the velocity of money.

However, nearly all economists would agree that expectations play a key role in price level determination. Intuitively, it simply does not make sense to believe that prices across our economy have nothing to do with the expectations of economic agents.

So, how do we incorporate a role for expectations in the quantity theory of money?

The answer is to go back to our simple model of price level determination and think about how an increase in the quantity of money (an expansion of the monetary base) might impact both the numerator and the denominator in our price level equation.

As discussed earlier, if the numerator in our equation is relatively unresponsive to monetary policy, then it must the denominator in our equation, the market value of money that acts as the transfer agent from “more money” to “higher prices”. But we also know that “more money” (an expansion in the monetary base) does not automatically lead to a sudden fall in the value of money.

So, what are the circumstances in which an expansion of the monetary base will lead to a decline in the market value of money?

In simple terms, the rule of thumb is that an increase in the monetary base will only lead to a decline in the market value of money if that increase is believed to be “permanent” in nature. Conversely, an expansion of the monetary base will have little to no impact on the market value of money is that increase is believed to be “temporary” in nature.

Money is a long-duration asset. The value of money depends primarily not upon what is happening today, or is expected to happen in the next couple of years, but what is expected to happen over the next 20-30 years. More specifically, money is a long-duration, variable entitlement to future output. The value of money depends primarily upon expectations of the long-term path of both real output and the monetary base,.

In and of itself, a change in the current level of the monetary base is largely irrelevant to current market value of money. What really matters is how that change in the monetary base impacts expectations regarding the long-term path of the monetary base.

Putting this in the context of quantity theory, the conclusion we can draw is that it is not an increase in money supply per se that leads to an increase in the price level (although this will tend to be true when measured over long periods of time). Rather, the price level will rise if a monetary policy shift is deemed by the markets to indicate that the future growth of the monetary base will be higher than previously anticipated. Such a shift in expectations will lead to an immediate decline in the market value of money and, correspondingly, a sudden rise in the price level.

In summary, quantity theory is an important idea, but it needs to be modified to reflect the fact that expectations matter. More specifically, long-term expectations regarding the future economic prospects of society are the key determinant of the market value of money, the denominator of the price level. Moreover, it is the market value of money that acts as the primary transmission point from “too much money” to “higher prices”, whereas the interaction between monetary expansion and aggregate demand is, at best, a secondary transmission mechanism.

Author: Gervaise Heddle

Does “Too Much Money” Cause Inflation?

Does money have any role in the determination of inflation? Does printing too much money cause inflation? And what does it mean to say “too much money”? “Too much” relative to what?

Milton Friedman once famously observed, “Inflation is always and everywhere a monetary phenomenon”. Less well known is his qualification to this statement. Friedman’s full observation was “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” (Friedman, “Money Mischief”, page 49)

Friedman’s qualification helps us narrow down our original question to the following, “Does too much money, relative to output, cause inflation?” Alternatively, we could ask, “Does growth in the monetary base that is significantly in excess of growth in real output cause inflation?”

Empirical evidence strongly suggests that, when measured over long periods of time, growth in the monetary base that is significantly in excess of growth in real output does lead to a concomitant rise in the price level. In this sense, Friedman’s observation appears to be correct.

However, over short periods of time, this relationship does not appear to hold. For example, over the past six or seven years, the monetary base of the United States has quadrupled, while real output has grown only modestly: yet the price level has barely moved higher.

So, why is this the case? Why does the quantity theory of money work over long periods of time, but not over short periods of time?

The view of The Money Enigma is that, over short periods of time, the primary driver of inflation is not the change in the current ratio of “base money/real output”, but the change in the expected 20-30 year future ratio of “base money/real output”. In other words, it is not the current level of growth in money relative to output that matters, but rather the expected long-term future growth of money relative to output that matters.

In this sense, it is not “too much money” that causes inflation, but the expectation of “too much money” being created over the next 20 years that matters.

Why might market participants suddenly expect a society to create too much money (relative to output) in the future? There are many possible reasons, but obvious reasons might include war, a secular decline in productivity, economic mismanagement, or just the sudden realization that a country has been living way beyond it means.

Inflation and the value of money

In the academic world, fashions come and go. In the late 1960s and early 1970s, there was much discussion about the role of money in the determination of inflation, a discussion that was led by the great minds of that time including Milton Friedman, Anna Schwartz and Philip Cagan.

Fast forward nearly fifty years, and it is not fashionable to discuss the role of money in the determination of the price level. Indeed, there is a view among many economists (notably, New Keynesian economists) that money is almost irrelevant to the discussion and that the size of the monetary base is only important in so far as it influences interest rates.

This is despite the fact that one of the strongest empirical relationships in economics remains the long-term correlation between the price level and the ratio of base money to real output. As Friedman once put it, inflation “…is and can be produced only by a more rapid increase in the quantity of money than in output.” This sentiment is clearly supported by the long-term data.

So, why is there such a disconnect? Why do academic economists largely dismiss the important role that the money/output ratio has in the determination of inflation?

First, the correlation between the price level and the money/output ratio breaks down in the short term. Although the quantity theory of money is valid over very long periods of time, it doesn’t work over short periods of time. Therefore, most economists feel comfortable ignoring quantity theory in their short-term forecasting of inflation.

Second, mainstream economics does not recognize the important role that the value of money plays in the determination of the price level. According to the orthodox view, the “value of money” has nothing to do with price determination!

Indeed, mainstream economics does not officially recognise the “market value of money” as a variable in any of its equations. Mainstream economics does not recognise the “market value of money” as a relevant economic variable because the view of mainstream (Keynesian) economics is that supply and demand for money determines the interest rate.

The view of The Money Enigma is that supply and demand for money (the monetary base) determines the market value of money (not the interest rate). In turn, the market value of money is the denominator of every money price in the economy and, therefore, is the denominator of the price level.

This general issue was discussed in a recent post titled “The Interest Rate is Not the Price of Money“. But rather than dwell on Keynesian theory, let’s briefly discuss how prices are determined at both a micro and macro level and then use this to continue with our discussion of the relationship between money and inflation.

What is a “price” and how is a price determined?

Price determination is a subject that we have discussed extensively over the past few months, so I don’t want to dwell on it in this post. We will discuss the basic principles today, but if you want more detail you should read the following posts:

“Every Price is a Function of Two Sets of Supply and Demand” (01/20/15)

“The Measurement of Market Value: Absolute, Relative and Real” (04/21/15)

“A New Economic Theory of Price Determination” (04/28/15)

In simple terms, the view of The Money Enigma is that every price is a relative expression of the market value of two goods.

Consider a simple exchange of two goods. Both goods must possess the property of market value in order for them to be exchanged. The price of the exchange simply measures the market value of one good in terms of another: the market value of a “primary good” in terms of the market value of a “measurement good”.

In our modern money-based economy, the measurement good most commonly used is money. The price of a good, in money terms, simply reflects the market value of the good relative to the market value of money. For example, if the price of a banana is $2, then we can say that the market value of one banana is twice the market value of one dollar.

The key point is that the price of a banana, in money terms, is a relative measure of value: it is determined not just by the market value of the banana (which can rise and fall) but also the market value of money (which can also rise and fall). If the market value of money falls, then, all else remaining equal, the price of the banana in money terms will rise.

In this sense, the market value of money is the denominator of every “money price” in the economy. In mathematical terms, the price of a good, in money terms, is a ratio of the market value of the good divided by the market value of money.

The trick to expressing this in terms of mathematical formula is recognizing that market value can be measured in the absolute. Just as we can measure any physical property in the absolute by using a “standard unit” of measurement for that property, so market value can be measured in the absolute by using a “standard unit” of measurement for market value.

The height of a tree can be measured using a standard unit for the measurement of height, namely “inches”. An “inch” is an invariable measure of the property of height. In economics, we can create an invariable measure of market value: a standard unit” for the measurement of market value that possesses the property of market value and is invariable in this property. Since no good exists that is invariable in market value, we need to create a theoretical measure, called “units of economic value”.

Once we have a standard unit for the measurement of market value, we can measure the market value of both goods being exchanged in terms of this standard unit. In other words, we can measure the market value of both goods in absolute terms.

This raises an obvious question: how is the market value of a good determined? In this respect, we can adapt an old paradigm: the market value of a good is determined by supply and demand for that good. If we plot supply and demand for each good in terms of our standard unit of market value, then we can see that the price of the primary good (good A) in terms of the measurement good (good B) is a function of two sets of supply and demand.

Supply and demand for the primary good (good A) determines the market value of the primary good. Supply and demand for the measurement good (good B) determines the market value of the measurement good. The price of the primary good in terms of the measurement good (the price of A in B terms) is the ratio of the market value of the primary good divided by the market value of the measurement good. This is a universal theory of price determination that we can apply to the determination of barter prices (good/good prices), money prices (good/money prices) and foreign exchange rates (money/money prices).

In a money-based economy, the price of a good, in money terms, is determined by the ratio of the market value of the good divided by the market value of money.

We can extend this microeconomic principle to a macroeconomic description of price level determination. If the market value of money is the denominator of every “money price” in our economy, then the market value of money is the denominator of the price level. (Remember, the price level is nothing more than a hypothetical measure of overall money prices for the set of goods and services that comprise the “basket of goods”.)

Once again, if we measure the overall market value of goods and services in terms of a standard unit of market value and denote this as V_G, and we measure the market value of money in terms of the same standard unit and denote this as V_M, then the price level is simply a ratio of V_G and V_M.

Ratio Theory of the Price Level simply states that the price level depends upon both the overall market value of the basket of goods and services and the market value of money. If the market value of the basket of goods and services is relatively stable over time, then the price level will be primarily determined by the direction of the market value of money. If the market value of money falls significantly over time, then the price level will rise significantly over that same period of time.

The determination of the market value of money

The view of The Money Enigma is that the market value of money is the denominator of every “money price” in the economy: the price of a good, in money terms, depends upon both the market value of the good and the market value of money.

If this theory is correct, then the market value of money plays a critical role in the determination of the price level and inflation. So, what determines the market value of money?

We have already hinted at part of the answer: supply and demand.

If every price is a function of two sets of supply and demand, then every money price must be a function of two sets of supply and demand. More specifically, the price of good A, in money terms, depends upon both supply and demand for good A and supply and demand for money (the monetary base).

As discussed in the introduction, the view of The Money Enigma is that supply and demand for money (the monetary base) determines the market value of money, not the interest rate. (The interest rate is determined by supply and demand for loanable funds).

While this might be an interesting first step, it really doesn’t tell us much about the factors that influence the value of money. In order to understand the specific factors that determine the market value of money, we need to develop a deeper understanding of what money is.

Over the past two weeks, we have discussed the nature of fiat money at length. In the first post, “The Evolution of Money: Why Does Fiat Money Have Value?” we traced the evolution of money from “commodity money” to “representative money” and finally to “fiat money”.

In that post, it was argued that representative money derives its value from an explicit contract: representative money is just a piece of paper that promises the holder of that piece of paper a real asset (normally, gold or silver) when that piece of paper is presented to its issuer.

When the gold/silver convertibility feature was removed, i.e. when the explicit contract was rendered null and void and the representative money became fiat money, the explicit contract was replaced by an implied-in-fact contract. In this way, fiat money derives its value contractually. Every asset derives its value from its physical properties (it is a real asset) or from its contractual properties (it is a financial instrument). Fiat money is not a real asset. Therefore, fiat money must be a financial instrument that derives its value from its contractual features.

The nature of the implied contract that governs fiat money was explored in a second post, “What Factors Influence the Value of Fiat Money?” While it is difficult to speculate on the exact nature of the implied contract, we can leverage finance theory to guide us in the right direction.

The view of The Money Enigma is that fiat money is a special-form, long-duration equity instrument issued by society. More specifically, fiat money represents a proportional claim on the future output of society.

And this brings us to the crux of the issue: what determines the value of fiat money and, consequently, the level of money prices in the economy?

If money is a proportional claim on the future output of society, then its value depends, at least primarily, upon future expectations of (1) real output, and (2) the size of the monetary base. Moreover, if money is a long-duration asset, then its value depends upon expectations regarding the long-term (20-30 year) path of these two important variables (real output and base money).

If the market suddenly decides that long-term (20 year) real output growth will be higher than previously anticipated, then the value of a proportional claim on that future output should rise (the market value of money should rise). All else remaining equal, the value of money will rise and the price level will fall.

In this example, there has been no change in current levels of real output or the monetary base, yet the price level has fallen. Why? The price level falls because it depends on the market value of money (the market value of money is the denominator of the price as per “Ratio Theory”). In turn, the market value of money depends upon long-term expectations. Current conditions really only matter to the market value of money to the degree that they impact expectations of long-term conditions. This is true of the value of any long-duration asset: current conditions are only important to the value of a long-duration asset in so far as they impact long-term expectations.

Now, let’s consider what happens if the market suddenly decides that the long-term growth rate of the monetary base will be much higher than previously anticipated. If money is a proportional claim on output, then more claims at some future point will mean that every claim is entitled to a smaller proportionate share of output at that future point. If the market decides that the future value of money will be lower, then this will have an immediate negative impact on the current value of money. Why? In simple terms, the market value of money depends upon a chain of future expectations regarding the future value of money.

Admittedly, this is a complicated concept and one that is explored in much greater detail in The Velocity Enigma, the third and final paper of The Enigma Series.

The key point that I wish to highlight is that, if proportional claim theory is correct, then the current market value of money depends upon the expected long-term path of both real output and the monetary base. Furthermore, since the market value of money is the denominator of the price level, the price level itself also depends upon the expected long-term path of both real output and the monetary base.

Bearing this in my mind, let’s return to our original question.

Does “too much money” cause inflation?

There can be little doubt that, over long periods of time (30 years+), growth in the monetary base that is greatly in excess of growth in real output will lead to a rise in the price level. There is strong empirical support for this observation.

This observation sits neatly with the theory that money is a proportional claim on the output of society. Over long periods of time, if the number of claims on output grows at a substantially faster rate than output, then the value of each claim should fall. In other words, if the monetary base grows at a substantially faster rate than output, then the market value of money should fall and the price level should rise (the market value of money is the denominator of the price level).

On the other hand, there is also compelling evidence to indicate that, over short periods of time, a dramatic increase in the monetary base can have little to no impact on the market value of money, even if the increase in the monetary base dwarfs any increase in real output during that same period of time.

This phenomenon has always been harder for economists to explain, but it can be explained by the theory that money is a special-form equity instrument and a long-duration, proportional claim on the future output of society.

If money is a long-duration, proportional claim on output, then the value of money will only be sensitive to changes in current levels of real output and the monetary base to the degree that changes in current levels impact expectations regarding the long-term path of both real output and the monetary base.

We can use a simple analogy from finance: the value of shares. The value of a share of common stock depends on the expected future cash flows that will accrue to the holder of that share. More specifically, a company’s stock price depends little on current earnings or current shares outstanding. Rather, the stock price is determined by expected long-term earnings per share. Therefore, it is the long-term path of both net earnings and shares outstanding that matter to the current value of a share of common stock.

Similarly, money is a long-duration asset and its value is primarily driven by expectations of the long-term real output/base money ratio, not by the current real output/base money ratio.

This has one important implication regarding market perception of monetary policy and its impact on inflation. If the market believes that a sudden rise in the monetary base is only “temporary” (it will be reversed in the next few years), then such an increase in the monetary base should have little to no impact on the value of money and, therefore, little to no impact on the price level.

However, if the market believes that a sudden rise in the monetary base is more “permanent” in nature, then that increase in the monetary base should lead to a fall in the value of money and a rise in the price level.

The view of The Money Enigma is that the dramatic increase in the monetary base in the United States has had little impact on the market value of the US Dollar (and little impact on the price level) because market participants believe that the increase is “temporary” in nature.

In slightly more sophisticated terms, the extraordinary actions of the Fed have not changed the market’s view regarding the long-term (20-30 year) path of the real output/base money ratio. Most market participants remain optimistic that real output will grow at solid rates for he next 30 years, even while the monetary base is reduced or at least capped at current levels. This has put a floor under the value of the US Dollar and a lid on the price level.

However, what happens if market expectations change? What will happen if the market becomes more pessimistic regarding the long-term economic prospects of the United States?

If market participants begin to believe that the Fed is unwilling or unable to reduce the monetary base, then this shift in expectations will begin to put downward pressure on the value of money and upward pressure on the price level. This fall in the value of money will be compounded if the market becomes more pessimistic about the long-term rate of real output growth in the United States. If this were to occur, then a return to double-digit levels of inflation is quite possible.

What Factors Influence the Value of Fiat Money?

Fiat money possesses the property of market value. Fiat money must possess this property in order for it to act as a medium of exchange. But what determines the market value of fiat money? Why does the value of fiat money fluctuate and tend to fall over long periods of time? Moreover, why does the value of a fiat currency sometimes fall sharply in a short period of time?

In last week’s post, we asked the question: “why does fiat money have value?” After all, fiat money is nothing more than a piece of a paper with pictures on it. Why does something with so little intrinsic/physical value have any value at all?

In this week’s post, we will attempt to answer an even more difficult, but related question: “what determines the value of fiat money?” In order to do this, we will discuss the nature of the implied contract that governs fiat money.

As discussed in last week’s post “The Evolution of Money: Why Does Fiat Money Have Value?” the view of The Money Enigma is that fiat money is a financial instrument and derives its value contractually.

All assets are either real assets or financial instruments. Real assets derive their value from their physical properties. In contrast, financial instrument derive their value from their contractual properties.

The first form of money used in most societies was commodity money. This early commodity money was a real asset and derived its value from its physical properties.

Over time, paper money was introduced. Originally, paper money was nothing more than an explicit contract that promised to its holder some weight of commodity money such as gold coin. This “representative money” derived its value from its contractual properties (it was a promise to deliver something of tangible value).

At some point, the explicit contract that governed paper money was rendered null and void. So why did paper money retain any value? The view of The Money Enigma is that the explicit contract governing paper money was replaced by an implied-in-fact contract between the issuer of money (society) and the holders of money.

By exploring the nature of this implied contract, the “Moneyholders’ Agreement”, we can begin to build a better picture of which factors influence the value of money. Furthermore, we use this perspective to think about why the value of fiat money tends to fall over time.

In simple terms, the view of The Money Enigma is that fiat money represents a proportional claim on the future output of society. Over long periods of time, an increase in the monetary base relative to real output will reduce the value of the proportional claim and lead to rising prices across the economy. We have seen this pattern exhibited repeatedly across most Western economies over the past fifty years.

Over short periods of time, expectations regarding the future path of the monetary base and real output are critical to the value of money. If people become more optimistic about the growth of future output, then the value of money will rise. Conversely, if people become less optimistic and believe that more money will have to be created to support the same level of future output growth then the value of money will fall and the price level will rise.

The Fiat Money Enigma

“Why does this asset have value?”

In the case of most assets, this isn’t a difficult question to answer. If we choose almost any asset at random, then we can answer this question by applying a simple paradigm: every asset is either a real asset, it derives its value its physical properties, or it is a financial instrument, it derives it value from its contractual features.

For example, land is a real asset that derives its value from its physical properties: its owner can grow crops or build shelters upon it. In contrast, a corporate bond is a financial asset that derives its value from its contractual properties: it entitles its holder to a fixed stream of future cash flows.

This paradigm provides us with a simple way to think about how any asset derives its value. Furthermore, this simple paradigm can be easily applied to early forms of money, namely commodity money and representative money.

Commodity money is a commodity that is used as a medium of exchange. The most obvious example of commodity money is gold. Commodity money is a real asset and derives its value from its physical properties.

Representative money is paper money that represents a claim against the issuer of that paper for a certain amount of a commodity on request. Stated in slightly different terms, possession of representative money makes the holder of that money party to an explicit contract that promises the delivery of a certain amount of a real asset.

The most obvious example of representative money is paper money that issued under a gold standard. In the case of the gold standard, each note issued was an explicit promise by the issuer of that note to deliver a certain amount of gold on request.

From the perspective of our “real versus financial asset” paradigm, representative money is a financial instrument. Representative money is an asset that derives its value from its explicit contractual properties.

The point is that we have one simple paradigm that can be used to explain why an asset, any asset, has value. Furthermore, this paradigm can be usefully applied to early forms of money, both commodity money and representative money.

Now, let’s ask the question: “why does fiat money have value?”

Surely, the best place to start in any attempt to answer this question must the simple “real assets/financial instruments” paradigm? After all, this paradigm seems to explain why almost any asset has value, including all the early forms of money.

Despite the strength and logical simplicity of the paradigm, most economists chose to ignore it in their analysis of fiat money. Rather, economists prefer to treat fiat money as something special, almost magical: an asset that is so unique and enigmatic that it is automatically considered to be an exception to the simple paradigm that applies to every other asset, including the early forms of money that preceded fiat money.

The problem is that by ignoring this paradigm, economists have been forced to venture into unchartered and dangerous intellectual territory. After all, if an asset doesn’t derive its value from its physical properties and it doesn’t derive its value from its contractual properties, then how does it derive its value?

Inevitably, economists have created “solutions” to this problem that seem to make sense at a superficial level, but quickly fall apart once you scratch the surface. One of the best examples of this is Keynes theory of demand for money as espoused in his “General Theory of Employment, Interest and Money”.

If you cut through all the flowery language used by Keynes, his key thesis is that demand for money depends on its usefulness as a medium of exchange and its relative attractiveness as a store of value.

Superficially, this sounds plausible. Money is useful as a medium of exchange and we do use it as a store of value. Therefore, one might be tempted to argue, as Keynes does, that the reason money has value (the reason there is demand for money) is because it performs these functions.

The problem with this argument is that it fails to recognize why money can perform its function in the first place. The only reason money can act as a medium of exchange is because money has value. Similarly, the only reason money can act as a store of value is because money has value!

You can’t build a theory of demand for money based upon its functions: money can only perform its function because there is demand for it! If you rely on the functions of money to generate demand for money (i.e. the functions of money are the mechanism by which money derives its value), then you have created a circular and fallacious argument.

Fortunately, there is a better, albeit much more difficult and intellectually challenging way to think about how money derives it value. Rather than trying to invent some “feel good” solution that falls apart as soon as we scratch the surface, we could try to apply our “real assets/financial instruments” paradigm to fiat money.

Clearly, fiat money is not a real asset. As noted by many, fiat money is often nothing more than a piece of paper with some ink on it. Therefore, it is fair to say that fiat money is not a real asset and does not derive its value from its physical properties.

This leaves us with only one alternative: fiat money is a financial instrument and derives its value from its contractual properties.

The difficult question, a question that very few economists have spent any real time considering, is what is the nature of the contractual agreement governing fiat money? Clearly, the terms of any contract will not be standard or straightforward (if they were, then speculation on this topic would be well advanced). But this shouldn’t deter us from this path: if we can propose a contractual solution that is plausible, then this is far better than trying to create an alternative paradigm to explain how one specific asset (fiat money) derives its value.

Think of it this way. Prima facie, what is the better approach to the answering the question “how does fiat money derive its value?”

Should we:

a). Try to apply an already well-established paradigm that accounts for how assets derives their value, even if that path poses some intellectual challenges in explaining how this particular asset derives its value; or

b). Attempt to create a new paradigm to explain how one, only one, of all the assets that are in existence derives its value in a manner that is completely independent from all other assets?

The view of The Money Enigma is that we need to make a concerted effort to explain fiat money within the context of the existing paradigm. Therefore, this requires us to explore and speculate upon the nature of the implied agreement that governs fiat money and from which fiat money derives its value.

The Implied Moneyholders’ Agreement

Before we speculate on the nature of the contractual agreement that governs fiat money, we need to consider a few important points.

First, it helps to give the agreement a name. For lack of a better term, we will call the contractual agreement that governs fiat money the “Moneyholders’ Agreement”.

Second, we need to be careful with our definition of “money”. For the purposes of this analysis, “money” is defined as comprising solely the monetary base. For reasons that should become clear from the following discussion, the monetary base is unique as a financial instrument. Most of the assets that economists describe as money, most notably bank deposits, are created by contractual arrangements between private parties such as banks and deposit holders. In contrast, the monetary base can only be issued by government (acting on behalf of society): the monetary base, “fiat money” in the purest sense of the term, can not be created by individuals, banks or corporations.

Third, we need to recognise that the agreement that governs fiat money is an implied-in-fact contract, not an explicit contract. What does this mean? It means that there is no explicit written contract that we can read, nor an explicit verbal contract that we can listen to. Rather, the Moneyholders’ Agreement is a contract that is created by a common or mutual understanding, an understanding that can be implied from the behavior of the parties to the contract.

The implied nature of the Moneyholders’ Agreement makes it difficult to speculate on the exact terms of that agreement. But we can try to draw up a sensible term sheet, drawing on insights from the nature of other financial instruments, and then think about how these terms might influence and impact the valuation of money. To the degree that we can use the price level to provide us with some evidence regarding how the valuation of money adjusts in response to various historic events and shifts in future expectations, we can then determine whether the posited terms of the Moneyholders’ Agreement seem realistic.

So, let’s begin trying to dissect the terms of the implied Moneyholders’ Agreement.

The process of creating any financial instrument begins with determining the counterparties to the agreement. Therefore, the first question that we need to ask is in relation to the Moneyholders’ Agreement is who are the counterparties to the contract?

Clearly, one of the parties to the agreement is the “moneyholder”, those people in possession of money. As illustrated in the diagram below, money is an asset to the holder of money. However, in order for a financial instrument to be an asset of one party, it must be a liability of another. So, who is the counterparty? Who is the issuer of money?

The view of The Money Enigma is that, from an economic perspective, society itself is the issuer of the monetary base. From a legal perspective, government is the issuer of the monetary base. However, from an economic perspective, government is an empty shell: it is nothing more than a legal vehicle created by society in order to achieve the economic and social outcomes that society desires. The assets of that vehicle are, in truth, assets that belong to all of us: the bridges, airports and tanks owned by the government are assets of our society. Similarly, the liabilities of that vehicle are, at least from an economic perspective, liabilities of society.

An easier way to think about this issue is in the context of government debt. From a legal perspective, government debt is a liability of the government. However, from an economic perspective, government debt is more aptly considered as a liability of society. More specifically, government debt is a claim against the future output of society.

If you’re not convinced about this, then it is worth thinking about why US government debt attracts such a high credit rating. Investors in US government debt don’t feel safe because it is “backed by the full faith and credit of the US government”. Investors believe that US government debt is a low risk investment because it is backed by the future prospects of the US economy, one of the most stable and diversified economies in the world. Ultimately, it is society, through the political process, that chooses whether to honor this “government” debt, a debt that only has value because it is, in truth, a liability of society and a claim against the future output of society.

The point is that both government debt and the monetary base are liabilities of government in name only: they are, from an economic perspective, liabilities of society itself.

This raises the next obvious question: what does society produce that it can offer to a counterparty of such an agreement? Remember, every financial instrument represents some sort of quid pro quo: you give me something of economic benefit today and I will give you something of economic benefit tomorrow.

So what can our society offer as consideration for the liabilities it creates? The answer is future economic output.

At a high level, the only way our society can pay for public expenditures and projects is by sacrificing economic output. We can pay for public projects with current economic output (raising taxes today), or we can pay for these projects with future economic output. However, in order to pay for projects with future economic output, we need to create a legal vehicle (government) that can act as the issuer of liabilities that represent a claim on future output.

Once again, we need to think about the role of government (a legal entity) and its relationship to society (a non-legal entity). The view of The Money Enigma is that one of the key roles of government is to act as a legal entity that can both hold the assets of society and issue liabilities on behalf of society. (Society can’t hold assets and issue liabilities directly because it is not recognised as a legal entity).

However, in order for government to issue any meaningful liabilities (notably, government debt and money), government must be authorized by society to issue claims against the future economic output of society. This mechanism is illustrated in the diagram below.

As discussed, government debt is an indirect claim on future economic output (government debt represents a claim to future taxes that are, in turn, a claim on future economic output).

In contrast, money (the monetary base) represents a direct claim on future economic output.

In very simple terms, the Moneyholders’ Agreement promises the receiver of money that in return for their output today, they will be able to use the money they receive to claim some portion of the output generated by society in the future.

For example, let’s assume that our society wants to build a new bridge. Rather than fund this bridge by raising taxes today or raising taxes tomorrow (issuing government debt), society decides to simply issue more claims against its output (money). You, as a building contractor, accept this newly printed money, not because of its valuable physical properties, but because it represents a claim against the future output of society.

Frankly, this basic concept is fairly straightforward. The trick is deciphering the exact nature of the claim on future output.

In finance, there are two primary types of contractual entitlement: (1) “fixed” entitlements, and (2) “variable” or “proportional” entitlements.

A corporation can issue liabilities that represent either a fixed or variable entitlement to its future cash flow. A liability that represents a fixed entitlement to future cash flow is known as a financial liability or debt instrument. In contrast, a share of common stock, the most common form of equity instrument, provides its holder with a variable or proportional claim on a stream of future residual cash flows.

The view of The Money Enigma is that society faces similar options when it decides to fund current government expenditures through the issuance of liabilities.

Government debt represents, at least in principle, a fixed entitlement to future economic output. Clearly, this analogy isn’t perfect because government can debase the value of the currency in which the debt is repaid, but at least at a high level, it is a reasonable comparison.

In contrast, money (the monetary base) represents a variable or proportional entitlement to future economic output. In this sense, money is an equity instrument. (Technically, the Moneyholders’ Agreement is an equity instrument and possession of money makes the money holder party to this equity instrument.)

However, if money is an equity instrument, then money must be a special form of equity instrument. Most notably, it doesn’t entitle the holder to a stream of future economic benefits, but rather a slice of future economic benefits. Whereas a share of common stock entitles its holder to a stream of future cash flows, one dollar provides its holder with a proportional claim on output that can be used only once (you can only spend the dollar in your pocket once).

This fact impacts the next unusual feature of money: the proportion of output that one unit of money can claim seems to go up and down often in a manner that bears little or no relation to the number of claims on issue (the size of the monetary base).

We have seen a real-life example of this phenomenon recently. As the monetary base in the United States has increased fourfold, the proportion of US economic output that one dollar claims has not fallen by 75%.

The reason this is the case is because in a state of intertemporal equilibrium, the value of money must discount expectations regarding the long-term path of both real output and the monetary base.

Let’s assume that the Moneyholders’ Agreement states that the “in principle” proportion of output that one unit of the monetary base can claim at a future point in time is the expected “baseline proportion” for that given future period. Furthermore, the baseline proportion at that future point in time shall be determined with reference to the initial baseline proportion at the time the Moneyholders’ Agreement came into effect (the day the fiat currency was launched) adjusted for the increase/decrease in the size of the monetary base since that time.

Now, will the proportion of output that one unit of money can buy today (the “realized proportion”) be equal to the “in principle” proportion of output that the same unit of money should be able to buy today (the current “baseline proportion”)? The answer is “probably not”.

The reason for this is that the value of money today discounts a chain of future expected values.

As mentioned, we can only spend the dollar in our pocket once. Therefore, we need to choose when to spend the marginal dollar in our possession: we could spend it now, in six months, in six years, or in twenty years.

Part of this decision process involves calculating what the value of that dollar in pocket will be over time. For example, if we think the value of the dollar in our pocket is about will significantly over time, then we will prefer to spend it now.

The problem is that if everyone suddenly decides that the value of money will fall significantly at some point in the future, then the value of money will fall today. If everyone decides that the value of money will fall in the future, then more people will attempt to spend money today and fewer people will be willing to accept money in exchange for real goods/services at the going rate.

In economic terms, a state of intertemporal equilibrium is disrupted. The only way to restore intertemporal equilibrium is for the value of money to fall until it reaches the point where people are indifferent about spending the marginal unit of money today, in 6 months or in 20 years.

Expectations of the “Real Output/Monetary Base” Ratio Are Key

Now, let’s bring this back to the terms of the Moneyholders’ Agreement. As discussed, money represents a proportional claim on the future output of society. The Moneyholders’ Agreement allows us to calculate the in principle proportion of output that one unit of money can buy at any point in the future (the baseline proportion at launch of the fiat currency adjusted for any increase or decrease in the monetary base).

If the market suddenly decides that, for much of the next 20 years, output growth will be lower than expected and the monetary base will be higher than expected, then what happens to the current value of a proportional claim on future output?

Clearly, the current value of that claim must fall: there is less future output for each unit of the monetary base to claim and there will be more claims against that future output (the size of the monetary base will be higher than previously anticipated).

Even though there has been no change in current output or current levels of the monetary base, the value of money depends upon a chain of future expectations and, therefore, must reflect expectations regarding the long-term path of real output and the monetary base.

Conversely, the opposite could be true. As we have seen recently in the United States, the monetary base can be increased dramatically, with little or no impact on the value of money, if the increase in the monetary base is perceived to be “temporary”.

Money is a long-duration asset: its value depends upon expectations of the long-term (20-30 year) path of the “real output/base money” ratio. It matters little to the value of money if this ratio falls and is expected to remain low for a few years. What matters is the long-term path of this ratio.

In this sense, the value of fiat money provides us with a gauge of market confidence regarding the expected long-term economic prosperity of the nation that issued it. Presently, global markets remain optimistic about the long-term economic future of the major fiat currency nations (US, Japan, Europe). However, if this confidence is eroded, then the value of those fiat currencies will fall, increasing the risk of a return of high levels of inflation in those nations.

Proportional Claim Theory vs Quantity Theory of Money

Proportional Claim Theory (the theory espoused above) provides us with a useful explanation for why the quantity theory of money works over long periods of time, but not over short periods of time.

If money is a proportional claim on the future output of society, then one would expect that over long periods of time, if the monetary base grows at a rate far in excess of real output, then the value of money would fall significantly and the price level would rise significantly.

However, as discussed above, over short periods of time, changes in the current ratio of “real output/base money” has little impact on the value of money. Money is a long-duration asset. Therefore, in the short-term, fluctuations in the value of money are driven primarily by shifts in expectations regarding the long-term future path of real output and the monetary base. Therefore, over short periods of time, the price level is primarily driven by swings in these future expectations.

This idea can be expressed more clearly by developing a valuation model for fiat money. If we combine Proportional Claim Theory and the notion of intertemporal equilibrium, we can derive a valuation model or “discounted future benefits” model for fiat money.

The valuation model for fiat money suggest that the value of money depends on not just current level of real output and the monetary base (q and M above), but also on expectations regarding the long-term growth rate of real output (g) and the long-term growth rate of the monetary base (m).

Not surprisingly, the value of money is positively correlated to confidence in the economic future of society. If people believe that output growth (g) will be strong and that monetary base growth (m) will be constrained, then this supports the value of money. Conversely, if people become more pessimistic about the growth of output relative to money, then this will undermine the value of money.

If you are interested in reading more about this issue or exploring some of the ideas discussed above, then please download The Velocity Enigma, the third and final paper in The Enigma Series.

Money as the Equity of Society

The view of The Money Enigma is that fiat money is a special-form equity instrument. More specifically, each unit of the fiat monetary base represents a proportional claim on the future output of society, just as a share of common stock represents a proportional claim on the future cash flows of a corporation.

The idea that fiat money is an equity instrument begins with a simple observation: fiat money is a financing tool. Society has three options when it wants to fund public activities: raise taxes, issue debt (government debt) or print money. The monetary base represents a way to fund the public activities that we are not prepared to pay for with current taxes or future taxes (government debt).

We can compare this to the financing options faced by a typical corporation. Most companies face three basic choices when considering the funding of new projects: use existing cash flows, issue debt or issue equity.

The choice of issuing debt or equity for a corporation can be a complicated one, but generally it boils down to one simple issue: does the corporation want to create fixed claims against its future cash flows or variable/proportional claims against its future cash flows?

In the case of a corporation, the equity issued by that corporation has value because it is a proportional claim against the future cash flows of the company. The holder of that equity is party to a shareholders’ agreement that promises equity holders a variable entitlement to the future cash flows of that business.

The view of The Money Enigma is that society faces similar financing choices to those faced by a corporation. Moreover, the fiat money issued by society is, in essence, very similar to a traditional equity instrument issued by a corporation. More specifically, it is the view of The Money Enigma that fiat money has value because it is recognised as a proportional claim against the future output of society.

In order to understand this somewhat complicated idea, it helps to think about the evolution of money. In particular, it helps to step back and think about why fiat money exists in the first place.

Why Does Fiat Money Have Value?

A few weeks ago I published a post titled “Why Does Money Exist? Why Does Money Have Value?” In that post it was argued that fiat money was first introduced by the ancient kings to fund the kingdom when their royal treasury was running low on gold. When the kings couldn’t find enough gold or silver to pay the army, they created IOUs, pieces of paper (or other objects) that represented a direct claim on the gold in the royal treasury and issued these pieces of paper to the soldiers.

This ancient fiat money derived its value contractually. Fiat money was, by definition, not a “real asset”: it didn’t derive its value from its physical properties. Rather, it derived its value from its contractual properties, i.e. it was a “financial instrument”.

Early fiat money was governed by an explicit contract: possession of this ancient fiat money entitled the holder to x ounces of gold or silver from the royal treasury. This form of financial instrument proved incredibly popular both with those who issued them and those who subsequently used them in trade. Indeed, this financial instrument became so popular that it became the predominant medium of exchange in most societies.

Importantly, it allowed societies to cheat: spend a bit more today than they really could afford by issuing more fiat money than they could credibly back with gold reserves. The cost of this “cheating” was debasement of the currency, a process that sometimes occurred in small, gradual increments and sometimes in an outright collapse (for example, in 1933, the value of the US Dollar fell dramatically as the peg moved from $20 per ounce of gold to $33 per ounce of gold overnight).

The point is that this form of public finance became an extremely attractive option to the ancient kings and then, as time passed, to the populace itself. So much so, that at some point in the 20^th century, most developed nations decided to take fiat money to the next step: abandon the gold convertibility feature altogether.

While we take non-asset backed fiat money for granted today, it is worth considering what a radical step the abandonment of the gold convertibility feature represents.

If we go back to the beginning of fiat money, the only reason it had any value, and hence the only reason that it was accepted in exchange, was because it represented an explicit contract between the holder of money and the issuer for the issuer to deliver a certain amount of gold (a “real asset”) on request. Without this explicit promise, the fiat money would have been worth nothing.

Jump forward a few hundred years and we, as a society, decide to abandon this explicit contract. So how is it possible for fiat money to retain any value?

The popular and misguided view taught in the textbooks today is that money retained its value because, by the time the gold convertibility feature was removed, fiat money was accepted as a “medium of exchange”. In other words, fiat money has value because it did have value, even if the entire basis for that value is now defunct.

The view that fiat money has value because it is a medium of exchange is a circular argument and a form of logical fallacy. Why does money have value? Because it is a widely accepted medium of exchange. Why is money a widely accepted medium of exchange? Because it has value.

Incidentally, this circular argument sits at the heart of Keynes’ liquidity preference theory. Keynes begins his thesis on money demand by arguing that people demand money because it is (1) a medium of exchange, and (2) a store of value. But Keynes never addresses the issue of why money is a medium of exchange and a store of value. Money can only act as a medium of exchange and store of value because there is demand for it (it possesses the property of market value). Arguing that the demand for money is derived from these functions creates a circular argument that is never addressed by Keynes.

In short, the textbook view doesn’t resolve this circular argument.

The Money Enigma breaks the circular argument by providing an alternative view on how money derives its value. Rather than deriving its value from its functions, which it can only perform because it has value, money derives its value from its status as a financial instrument.

Money is a financial instrument. This means that money must derive its value contractually, even if that contract is implied. When the explicit contract was rendered null and void (the gold convertibility feature was dropped) another, albeit implied-in-fact contract must have taken its place in order for money to retain any value.

Now we get to the fun part. If money is a financial instrument, then what is the contractual agreement that is in place between the issuer of money (society) and the holders of money (individual members of society)?

What is the Nature of the “Moneyholders’ Agreement”?

Just as a shareholders’ agreement governs the contractual relationship between the issuer of common stock and the holders of that stock, so the implied-in-fact “Moneyholders’ Agreement” governs the contractual relationship between the issuer of money and the holders of money.

Since there is no explicit contract, or at least no explicit contract that is meaningful, unraveling the terms of the Moneyholders’ Agreement involves a degree of speculation. But we can at least apply the framework that is used for traditional financial instruments so that we know the right questions to ask.

Every financial instrument must possess certain characteristics in order for it to have value. First, it must entitle the holder of the instrument to some future economic benefit, a future economic benefit that the issuer has the capacity to offer. Second, it must entitle the holder to either a fixed or variable (proportional) claim against that future economic benefit.

For example, in the case of shares of common stock, each share entitles the holder to a future economic benefit (future cash flows) that the issuer (the issuing company) has, at least in principle, the capacity to offer. Furthermore, it entitles the holder to a proportional claim against that future economic benefit (the proportion of future residual cash flows each share claims varies in proportion to the number of shares issued).

Let’s think about these two characteristics and how they apply to the monetary base.

First, if base money is a financial instrument issued by society, then what future economic benefit can society offer to the holder of money? Let’s put this question another way. What does society have that it can use to pay its bills?

The answer is “economic output”.

If we circle back to the beginning of this post, we noted that society has three ways to pay its bills: taxes, debt or money. Taxes are a claim on current economic output. Government debt represents a claim on future economic output.

If society doesn’t wish to pay for current public expenditures by sacrificing current economic output, then it can issue claims against future economic output. Moreover, just as a corporate entity can issue fixed or variable claims against future cash flows, so society can issue fixed or variable claims against future economic output.

Money, the monetary base, represents a variable or proportional claim against the future economic output of society.

Now, why does this matter? The reason this should matter to economists is because we can use this idea to build a valuation model for the market value of money. In turn, the market value of money is the denominator of every money price in the economy and, therefore, the denominator of the price level.

In theory, we should be able to build an expectations-based discounted future benefits model for money just as we can build a discounted future cash flow model for a share of common stock. But there are some nuances and complications.

Those with a financial analyst background will notice one immediate difference between money and a share of common stock: a share of stock entitles you a stream of future cash flows, whereas the dollar in your pocket entitles you to a slice of future economic output (you can only spend the dollar once).

This distinction creates an interesting challenge. A valuation model for money must incorporate a probability distribution for the future time at which the marginal unit of money demanded is expected to be spent. It turns out that this issue is easily resolved by the application of intertemporal equilibrium theory.

There are several other complications that are addressed at length in The Velocity Enigma, the third paper in The Enigma Series. For the sake of time, we won’t discuss these now, but those that are interested can read all about it in The Velocity Enigma, the third and final paper in The Enigma Series.

The end result is a valuation for model for money, called “The Discounted Future Benefits Model for Money” that looks very similar to a valuation model for a share of common stock. The equation below is expressed in terms of a “standard unit” or invariable measure of the property of market value. In this sense, the market value of money is measured in absolute terms.

The equation above states that the market value of money is a function of:

The current levels of real output, q_t
The current level of the monetary base, M_t
The current level of the general value level, V_G,t
The expected long-term growth rate of real output, g
The expected long-term growth rate of the monetary base, m
The expected long-term risk-adjusted nominal return on risk assets, i
The real discount rate applied to future consumption, d

In simple terms, the valuation model implies that the market value of money depends critically upon the expected future path of the “real output/base money” ratio. If expectations about the long-term prospects of the economy become more pessimistic, i.e. slower output growth that is supported by higher base money growth, then the market value of money will fall.

Let’s put this in a more familiar context.

The value of a share of common stock will fall if people believe that a company’s long-term cash flow growth will slow while share issuance will rise.

Similarly, the value of money will fall if people believe that a society’s long-term output growth will slow while base money issuance will rise.

In this sense, money is very similar to any other equity instrument. The value of any particular fiat currency is ultimately a bet on the true prosperity of the society that has issued it.

Finally, I will leave you with two more slides. The slides below illustrate the critical end result: an expectations-adjusted quantity theory of money. While the price level does depend to some degree upon current levels of real output and base money, it is expectations of the long-term path of these variables that is critical to the determination of the price level.

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