What gives money value? We know that intrinsically, a
dollar bill is just worthless paper and ink. However, the
purchasing power of a dollar bill is much greater than
that of another piece of paper of similar size. From
where does this power originate?
Like most things in economics, there is a market for
money. The supply of money in the money market comes from
the Fed. The Fed has the power to adjust the money
supply by increasing or decreasing the number of bills
in circulation. Nobody else can make this policy
decision. The demand for money in the money market
comes from consumers.
The determinants of money demand are infinite. In
general, consumers need money to purchase goods and
services. If there is an ATM nearby or if credit cards
are plentiful, consumers may demand less money at a given
time than they would if cash were difficult to obtain.
The most important variable in determining money demand is
the average price level within the economy. If the
average price level is high and goods and services tend to
cost a significant amount of money, consumers will demand
more money. If, on the other hand, the average price
level is low and goods and services tend to cost little
money, consumers will demand less money.
Figure %: Sample money market
The value of money is ultimately determined by the
intersection of the money supply, as controlled by the
Fed, and money demand, as created by consumers. Figure 1
depicts the money market in a sample economy. The money
supply curve is vertical because the Fed sets the amount
of money available without consideration for the value of
money. The money demand curve slopes downward because as
the value of money decreases, consumers are forced to
carry more money to make purchases because goods and
services cost more money. Similarly, when the value of
money is high, consumers demand little money because goods
and services can be purchased for low prices. The
intersection of the money supply curve and the money
demand curve shows both the equilibrium value of money
as well as the equilibrium price level.
Figure %: Sample shift in the money market
The value of money, as revealed by the money market,
is variable. A change in money demand or a change in the
money supply will yield a change in the value of money and
in the price level. Notice that the change in the value
of money and the change in the price level are of the same
magnitude but in opposite directions. An increase in the
money supply is depicted in Figure 2. Notice that the new
intersection of the money supply curve and the money
demand curve is at a lower value of money but a higher
price level. This happens because more money is in
circulation, so each bill becomes worth less. It takes
more bills to purchase goods and services, and thus the
price level increases accordingly.
The quantity theory of money is based directly on the
changes brought about by an increase in the money supply.
The quantity theory of money states that the value of
money is based on the amount of money in the economy.
Thus, according to the quantity theory of money, when the
Fed increases the money supply, the value of money falls
and the price level increases. In the SparkNote on
inflation we learned that
inflation is defined as an increase in the price level.
Based on this definition, the quantity theory of money
also states that growth in the money supply is the primary
cause of inflation.
