THE LEVEL OF PRICES AND THE VALUE OF MONEY

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THE LEVEL OF PRICES AND THE VALUE OF MONEY

Suppose we observe ?some period of time the price of an ice-cream cone rising from a nickel to a  dollar. What conclusion should we draw from the fact that people arc willing to give lip so much more money in exchange for a cone? It is possible that people have come to enjoy ice cream more (perhaps because some chemist has developed a miraculous new flavor). Yet that is probably not the cascara It is more likely that people’s enjoyment of ice cream has stayed roughly the same and that, over time, the money used to buy ice cream has become less valuable, Indeed, the first insight about inflation is is more about the value of money than about the value of goods.

This insight helps point the way toward a theory of inflation. When the consumer price index and other measures of the price level rise, commentators arc often tempted to look at the many individual prices that make up these price indexes: “The CPI rose by 3 percent last month. led by a 20 percent rise in the price of coffee arid a 30 percent rise in the price of heating oil.” Although this approach docs contain some interesting information about what’s happening in the economy, it also misses a key point: Inflation is an economy-wide phenomenon that concerns, first and foremost, the value of the economy’s medium of exchange.

The economy’s overall price level can be viewed in two ways. So far, we have viewed the price level as the price of a basket of goods and services. When the price level rises, people have to pay more for the goods and services they buy. Alternatively, we can view the price level as a measure of the value of money. A rise In the price level means a lower value of money because each dollar in your wallet now buys a smaller quantity of goods and services.

It may help to express these ideas mathematically, Suppose P, is the price level as measured, for instance, by the consumer price index or the GDP defoliator, Then P measures the number o f dollars needed ‘ to buy a basket of goods and services. Now turn this idea around: The quantity of goods and services that can he bought with $1 equals liP. In other words, if P is the price of goods and services measured in terms of Vernon. I,P is the value of money measured in terms of goods and services. Thus, when the overall price level sens, the value of money falls.

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THE LEVEL OF PRICES AND THE VALUE OF MONEY