Friday, April 25, 2008

The Value of Money

So far I have discussed money supply, and the sensibility of a deflationary recession in the event of a credit contraction. Posts have focused on the big picture; relevant details and errors of generalization will be handled in due time. Generalities for now will suffice to proceed with the thesis: mainly, the cash investor should keep an eye on printed currency and credit, and of the two, printing is the more worrisome.

In order to decide if cash is worth a lot or a little, it is necessary to determine its value. Modern economics regards the “value” of money in terms of its exchange rates against foreign currencies. I’d like to offer a complimentary definition based on the actual function of cash: buying goods.

I submit the value of money (V) is determined predominantly by two factors:

(1) it is directly correlated with the inventory of goods (I) available (e.g. if more goods can be purchased with less money to go around, that would increase its value; or if nothing can be purchased with a given currency, then it is worthless); and

(2) it is inversely correlated with the supply of money in circulation (if money is readily available it will be less precious, and vice versa). For money supply, as usual, I use the Austrian definition of printed currency (P) + credit (C).

So V = I/(P+C). The unit of value is goods per dollar. Sharp-eyed readers will notice this is the inverse of prices (cost per unit). Only scarce goods factor into the inventory—if someone wants to sell buckets of mud, more of that is available than is desired, so it can be had for free.

Now, the usual definition of inflation is a general increase in prices, and deflation would be the reverse. (Similarly, we could invert this and define inflation and deflation in terms of cash value.) The problem either way is that price changes (and their inverse) are affected by many factors—e.g. availability, cost of production, and changing preferences over time—such that any conclusions one can draw from prices about monetary policy are at best vague. Prices of commodities (i.e. wheat and oil are going up lately) behave differently from assets (e.g. houses and stocks are even or going down), and the prices of services is driven by different forces still.

The Austrian school defines inflation as an increase of the money supply, and deflation is a decrease. This is right; the common definition is wrong. Prices are a function of inflation and deflation—not the reverse, since prices are also a function of inventory, which is unrelated to money supply.

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