In a recent post I argued that money matters for real variables like the unemployment rate. But it’s surprisingly hard to explain why, requiring a roundabout analysis. First we’ll need to explain why money matters for nominal variables like inflation and NGDP. Only then will we be able to return to the even more difficult problem—the business cycle.
This post will cover a few basics that experienced readers will wish to skip. The key concept with be the “value of money,” which can be defined as:
Value of money = 1/(price level)
This definition actually comes out of basic microeconomics. In upper level micro classes we move away from simple supply and demand curves, and start talking about “relative prices,” or “real prices.” Thus if the CPI rises 10% per year, then goods going up 8% are seeing their price fall in relative terms and those experiencing 12% price increases see their relative price increase. The relative price is the actual price relative to the price of all other goods in the economy. Now let’s do the same with money. What’s the nominal price of money? The answer is one. What’s the real price? It’s the purchasing power of money, how many goods you can buy with each dollar, which is simply 1/price level. Thus if the price level doubles then the purchasing power of money, i.e. its value, falls in half.
The field of monetary economics exists for one reason, and one reason only—money is the medium of account, the good we use to measure all other values. Most textbooks oversimplify this concept, combining two ideas into “unit of account.” Currency notes are the medium of account, the thing used to measure value. Abstract accounting units like the US dollar, the Canadian dollar, and the euro are examples of a unit of account.
Because money is the good in terms of which all other goods are priced, changes in the value of money are associated with changes in the price level, and in other nominal variables as well. Note that this is not a “theory,” it’s a definition. Theory will come in later, when we ask whether government policymakers can control the price level via “monetary policy.”
Irving Fisher liked to use the metaphor of money as a measuring stick (of value.) First we’ll do an example with the price level, then the same example with measuring sticks:
Year Income Price level Real Income
1978 $20,000 1.0 $20,000
2013 $120,000 3.0 $40,000
So prices have tripled over the past 35 years. The person’s income rose by 6-fold. How much better off are they? They can now buy twice as many goods and services. Technically this is derived as follows: real income = $120,000*(1.0)/(3.0). Now let’s do the same example with the height of the child:
Year Height Real height
1978 1 yard 1 yard
2013 6 feet 2 yards
The child grew 6-fold in nominal terms, but is only twice as tall in real terms. Everyone would scoff if a proud father claimed his son was now 6 times taller, and yet someone who claims to be making 6 times as much money in 2013 as in 1978 is making the exact same mistake. They are implicitly assuming that 1978 dollars are the same thing as 2013 dollars. But each dollar today only has 1/3 the value of a 1978 dollar. We would say they suffer from “money illusion.”
Suppose something other than cash had been used as money. If apples were money, then a huge apple harvest that lowered the value of apples would cause lots of “inflation.” In fact every time the relative price of apples falls sharply we do have lots of “apple inflation.” And when the relative value of silver soars we have lots of “silver deflation.” Why do we only care about money inflation, not the other types of inflation and deflation? That’s a surprisingly hard question to answer. In textbooks it’s covered in two different sections:
1. The welfare costs of inflation.
2. The welfare costs of business cycles.
In theory measuring sticks should not matter very much. Whether you measure things using foot long rulers or yardsticks doesn’t affect their actual size. But imagine a kingdom where for some strange reason people made contracts to supply 100 “units of wheat” 12 months in the future, where units were left unspecified. Or they agreed to work for the next year at a wage of 2 units of wheat per hour. Also assume the king could change the units from kilos to pounds to ounces whenever he wished. Now a change in units certainly would affect the public. And that’s the primary reason why monetary inflation is important and apple inflation matters very little (except for apple farmers and consumers.) Our measuring stick of value (money) is itself always changing in value, and this causes all sorts of problems.
An economist once said; “money is a veil [hiding the real economy], but when the veil flutters, real output sputters.”
Next we need to explain why the value of money changes over time. Another couple posts.
PS. A NASA satellite once crashed because some parts had been measured in inches rather than centimeters, and were mismatched.
PPS. Some journalists define the value of money in terms of its ability to buy other monies. This is an odd definition, but the math is the same. The dollar price of euros is 1/(euro price of dollars). Even weirder are those who define the value of money in terms of a very scarce but heavy yellow metal. Later we’ll see that there is one arbitrary definition of the value of money that might be even more useful than the standard definition: The share of nominal GDP that can be bought with each dollar.