How the Value of Money Is Determined

Who Decides How Much Money Is Worth

Title reads: "3 ways to measure the value of a dollar: 1) exchange rates 2) the demand for treasury notes 3) the foreign exchange reserves" Image shows a small bill being equivalent to 6 foreign coins, and then shows a visual implying that when the demand of large bills goes up and down, so does the demand for small bills. The last image is three administrative buildings from various foreign countries next to a stack of dollar bills.

Image by Theresa Chiechi © The Balance 2019

The value of money is determined by the demand for it, just like the value of goods and services. There are three ways to measure the value of the dollar. The first is how much the dollar will buy in foreign currencies. That’s what the exchange rate measures. Forex traders on the foreign exchange market determine exchange rates. They take into account supply and demand, and then factor in 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 Treasurys.

When the demand for Treasurys is high, the value of the U.S. dollar rises.

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.

No matter how it's measured, the dollar's value declined from 2000 to 2011. That was due 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 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.

How It 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 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. It will reduce the money supply or raise interest rates to curb inflation. A healthy economy can sustain a core inflation rate of 2%. 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 It Increases

Federal Reserve Bank of San Francisco. 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. Prices dropped more than 20%. 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 $26.07 could purchase in 2020. The dollar lost value slowly. By 1920, it could buy what $12.91 could in 2020.

During the Great Depression, money gained in value as a result of deflation. A dollar in 1930 could buy what $15.46 could in 2020. By 1950, money had lost some value. A dollar could buy what $10.71 could buy in 2020.

Money has been losing value ever since. In 1970, it could only buy $6.65 in 2020 terms. By 1990, it was only worth $1.97, also in 2020 terms. In 2000, it was worth $1.50 in 2020 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 these factors:

  • Exchange rate value.
  • Value of Treasury notes.
  • 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 one of the Federal Reserve’s most important functions.