It is much easier to value a Big Mac…
You work, and wealth is transferred to you using dollars. You know how many dollars you earn each week, but how much wealth do you receive?
Good question. Depends on how much wealth each dollar stored that day.
Dollars are a financial asset, and like all other financial assets, its value, the amount of wealth we collectively believe it represents, is very influenced by the economic forces of supply and demand.
As our currency, dollars are also our single unit of accounting, which is a fancy way of saying that everything is priced in dollars. Which is why we say that a Big Mac today costs about six dollars. It is just as accurate to state that a dollar is worth about 1/6 of a Big Mac, but no one does, because that would imply that Big Macs are our standard unit of accounting. Mmmm.
Perhaps this is not all together silly. Consider that the ingredients of a Big Mac have never changed, and that the preparation of a Big Mac has always required about the same amount of work. This implies that fresh off the grill Big Mac stores about the amount of wealth today as it did thirty-five years ago. It would be a constant unit of accounting, kind of like the meter, the scientific unit of measurement for length.
While the wealth represented in a Big Mac has been constant, back in 1986 a Big Mac cost about $1.60. Meaning that amount of wealth that we all believe that a dollar stores has dramatically fallen, by a factor of 4.
As good as they are at holding value, I think that we all know that Big Macs would not make a good money. Which leaves us with the dollar.
Why has the dollar lost so much value? Wouldn’t it be a better money if its value remained constant, that the amount of wealth stored and transmitted per dollar was constant? Yes, it would, but thanks to government deficits, that is not the world we live in.
Unlike the supply of Big Mac, which are prepared to order, the supply of dollars has grown much faster than needed, as reflected in price inflation, the devaluation of the dollar that we experience year after year.
In the long term (decades), there appears to be a strong correlation between changes in the money supply (the amount of dollars in circulation), and the value of the dollar. In the short term (years), the situation is much more complex.
The economic forces on the value of the dollar are:
- The faith in the dollar as a money
- The money supply (per capita)
- The aggregate supply of goods and services
- The aggregate demand of goods and services
- The velocity of money
- The rate of inflation
- Interest rates
- The Forex (Foreign Currency Exchange)
- The dollar’s status as a global reserve currency
The short-term value of the dollar will either increase or decrease per the combination of these many forces, making it exceedingly difficult to predict the changes in the dollar’s value in this time frame.
This cannot all be explained in a single blog entry, but let us pick one, the aggregate supply for goods and services, and model how it impacts the value of the dollar.
Items can be purchased only if they are available for sale. The aggregate supply is a measurement of the value of all goods and services available for purchase within a given economy, during a given period.
Consider a simple one-village economy with a fixed amount of gold coins in circulation as its currency.
As established by the past forces of supply and demand on the value of money, one gold coin stores enough wealth to purchase a dozen eggs at the market.
Now consider the situation where the following week the chickens only lay half the normal amount of eggs, resulting in a “supply shock”, a sudden and dramatic reduction in the supply of eggs.
Assuming that within this short time frame the demand for eggs remains constant (the villagers like quiche), and the wealth storage capacity of the gold coin changes slowly due to “stickiness,” (it takes time to change a collective belief), it stands to reason that one gold coin will now buy just six eggs, because the supply of eggs has been reduced by one half. The eggs have increased in value relative to everything else money can buy. Of course, this assumption of “constant demand” is unrealistic, as when the price of any good increases, the demand for that good tapers off. There are other choices for protein, after all.
Will compromise and assume that one gold coin will now buy somewhere between 6 and 12 eggs. Or to put it another way, the price of the eggs increased by a little or a lot.
But the price of eggs did increase.
Now extrapolate to the case of many goods having their supply reduced in a relatively short time frame. It stands to reason that just like with the eggs; a single gold coin will buy less of the goods for which there is a shortage.
What just happened? With all other economic forces being constant, but with less goods available for purchase, each gold coin has, on average, less purchasing power.
If the aggregate supply of goods and services decreases and if all the other economic forces are strangely constant, then the value of the dollar will decrease, inflation happens. If the aggregate supply increases, all else being constant, deflation happens.