What Gives Money Its Value?

The value of money is determined by the demand for it, just like the value of goods and services. You can measure the value of money by what people will exchange for it and by how much of it there is.

Learn how the value of money is determined and who decides it.

How To Measure the Value of the Dollar

There are three ways to measure the value of the dollar.

Foreign Exchange Rate

The first way to measure the value of the dollar is by how much the dollar will buy in foreign currencies. That's what the foreign exchange (forex) rate measures. Forex traders on the foreign exchange market determine exchange rates. They take into account supply and demand, and then they factor in their expectations for the future. For this reason, the value of money fluctuates throughout the trading day.

Treasury Note Values

The second method to measure the value of the dollar is the value of Treasury notes. They can be converted easily into dollars through the secondary market for Treasurys. When the demand for Treasurys is high, the value of the U.S. dollar rises.

Foreign Exchange Reserves

The third way is through foreign exchange reserves. That is the amount of dollars held by foreign governments. The more they hold, the lower the supply. That makes U.S. money more valuable. If foreign governments were to sell all their dollar and Treasury holdings, the dollar would collapse. U.S. money would be worth a lot less.

Why the Dollar Changes in Value

No matter how it's measured, the dollar's value declined from 2000 to 2011. That was due to a relatively low federal funds rate, a high federal debt, and a slow-growth economy.

Since 2011, the U.S. dollar has risen in value despite these factors. Why? Most of the economies in the world had even slower growth. That made traders want to invest in the dollar as a safe haven. As a result, the dollar strengthened against the euro.

What Is the Time Value of Money?

Money also has a time value. Money today is worth more than money in the future because today's money can be invested and grown. To calculate the time value of money (TVM), you must consider the present value, the time frame available, and the rate at which it can grow.

Here is an example of finding the time value of money. If you had $100 in present value, a 5% interest rate, and interest that compounds annually, you would be able to calculate the future value of the money after one year.

FV = $100 x [1 + (5% / 1)] ^{(1 x 1)} = $105

You would have $105 in future value.

How the Value of Money Affects You

The value of money affects you every day at the gas pump and the grocery store. Demand for gas and food is inelastic. Producers know you have to buy gas and food every week. It's not always possible to delay purchases when the price rises.

Producers will pass on any of their extra costs. You will buy it at the higher price for a while until you can change your habits.

When the Value of Money Steadily Declines

Inflation is when the value of money steadily declines over time. Once people expect that prices will rise, they are more likely to buy now, before prices go higher. That increases demand, which tells producers they can safely pass on more costs. They drive prices up more, and inflation becomes a self-fulfilling prophecy.

That's why the Federal Reserve watches inflation like a hawk. It will reduce the money supply or raise interest rates to curb inflation. Core inflation is the price of everything except food and gas prices, which are very volatile. The Consumer Price Index is the most common measure of inflation.

When the Value of Money Increases

Deflation occurs when the general price level across the economy declines. That sounds like a great thing, but it is worse for the economy than inflation. Why? Think about what happened to the housing market from 2007 to 2011. That was massive deflation. Many people could not sell their houses for what they owed on their mortgage. Buyers were afraid that the price would drop right after they purchased it. No one knew when prices would turn back up.

True, the value of money increased. You received more house for the dollar in 2011 than in 2006. But families lost homes. Construction workers lost jobs. Builders went bankrupt. That's what makes deflation so dangerous. It's a fear-driven downward spiral.

How the Value of Money Has Changed Over Time

In 1913, money was worth a lot more. A dollar then could buy what $29.04 could purchase in 2022. The dollar lost value slowly. By 1920, it could buy what $14.38 could in 2022.

During the Great Depression, money gained in value as a result of deflation. A dollar in 1930 could buy what $17.22 could in 2022. By 1950, money had lost some value. A dollar could buy what $11.93 could buy in 2022.

Money has been losing value ever since. In 1970, it could only buy $7.41 in 2022 terms. By 1990, it was only worth $2.20, also in 2022 terms. In 2000, it was worth $1.67 in 2022 terms.

The Bottom Line

Because of inflation, your dollar today is worth more than it will be in the future. But the day-to-day value of money fluctuates as well because of the volume of demand for it. Dollar demand is measured by the exchange rate value, the value of Treasury notes, and the amount in foreign exchange reserves.

Although rising prices will lessen the purchasing power of money, generalized decreasing prices or deflation can be bad for the economy. Yes, deflation will certainly raise the value of money or its purchasing power. But it's the fear of rapidly plunging prices that will make people hold on to their money, lessen aggregate demand for goods and services, and cause a serious slowdown in economic activity. This makes monitoring and managing inflation and deflation two of the Federal Reserve's most important functions.

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