What Is the Value of Money?

Who Controls How Much Your Money Is Worth?

Value of money
The value of money is determined by three factors. Photo: Oleg Prikhodko/Getty Images

The U.S. Dollar Measures the Value of Money in America 

In the United States, the U.S. dollar determines the value of money. There are three ways to measure the value of the dollar. The first is how much the dollar will buy in foreign currencies. The exchange rate measures that value. Forex traders on the foreign exchange market determine that value. They take into account current supply and demand, as well as their expectations for the future.

For this reason, the value of money fluctuates throughout the trading day.

The second method is the value of Treasury notes. They can be converted easily into dollars through the secondary market for Treasuries. When the demand for Treasuries is high, the value of all money in America rises. 

The third way the dollar's value is measured is by 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 their dollar and Treasury holdings, the dollar would collapse. Then U.S. money would be worth a lot less.

No matter how it's measured, the dollar's value declined from 2000 to 2011 thanks to a relatively low Fed 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 are slowing down, which makes traders want to invest in the dollar as a safe haven.

For more, see Euro to Dollar Conversion

How Does It Affect You?

You notice the value of money most directly at the gas pump and the grocery store. That's because the prices of gas and food are inelastic.  Producers know you have to buy gas and food every week. You can't easily delay purchases when the price rises.

They will pass on any of their extra costs. You buy it at that price for a while before reducing your demand for that item. When the price of gas or food goes up, you are experiencing the reduced value of money.

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, and will reduce the money supply to curb inflation. However, a healthy economy can sustain a core inflation rate of 2%. Core inflation is the price of everything except those volatile food and gas prices.  The Consumer Price Index (CPI) measures inflation.

When It Increases

Deflation is when the value of money increases. 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 2007-2011, when there was massive deflation. Prices dropped more than 20%, and many people could not sell their houses.

People were afraid to buy because they didn't want to lose the value of the home. True, the value of money increased - you got more house for the dollar than in 2006 - but no one knew when prices would turn back up. Families lost homes and jobs. That's what happens in deflation - it's a downward spiral of fear.

How Has the Value of Money Changed Over Time?

In 1913, money was worth a lot more. A dollar then could buy what $22 purchased in 2010. The dollar lost value slowly. By 1920, it could buy what $10 does today. During the Great Depression, money gained in value. It could buy what $13 does today. By 1950, money had lost some value. A dollar could buy what $10 does today. Money has been losing value ever since. In 1970, it could only buy what $5.62 could buy today. By 1990, it was only worth $1.67 in today's terms.

For more, see Value of a Dollar Today