Value of Money

Value of Money

The value of money has to do with the purchasing power of a unit of money. One approach to the measurement of money value is to look at its precious metal equivalent. Under a gold standard, a dollar should be worth approximately a dollar’s worth of gold. Under a gold coin standard, the value of a dollar could drop below a dollar if the government reduces the gold content of its coinage relative to its face value. Under such circumstances it might be appropriate to say that a dollar is worth only 75 cents or 50 cents, based upon the value of its precious metal content.

Despite the widely hailed virtues of precious metal backing for money, the amount of precious metal a unit of money can buy is not the essential factor to individual consumers, who have to think of the cost of things they must buy to maintain themselves and their families. Furthermore, under an inconvertible paper standard such as that of the United States, where even the metallic coinage is token money, the value of money is divorced from any precious metal connection. The true measure of money value must be measured in terms of its purchasing power.

The value of money can only be measured relative to its value at a point in time. Assume that $1 is equal to $1 in 1987. If prices double from inflation in the following decade, and in 1997 it takes $2 to buy what $1 would have bought in 1987, then it would be appropriate to say that today’s dollar is worth only 50 cents.

In practice government statisticians and economists calculate price indices, such as the wholesale price index, the consumer price index, or the GDP deflator, which show the ratio of a weighted average of prices in a given year over a weighted average of prices in some arbitrarily selected base year. If the base year is 1987, then the price index is set to 100 for that year. If prices go up 10 percent over the following year, then the price index for 1988 will be 110, indicating that it takes $1.10 to purchase what $1 would buy the year before.

In 1998 the United States GDP deflator (base year = 1987) stood at 137.33. The value of a dollar can be calculated by dividing 137.33 into 100 (100/137.33), which equals 0.73, indicating that a dollar was worth only 73 cents in 1998. Keeping the base year at 1987, the GDP deflator for 1970 equals 34.5. The value of the 1970 dollar equals 100/34.5, or $2.90, meaning a dollar in 1970 was worth $2.90 cents relative to a 1987 dollar. In this context it would be appropriate to say that a dollar in 1970 was worth $2.90.

For a currency to be useful as a store of value and standard of deferred payment, it must maintain its purchasing power. A general rise in prices, commonly known as inflation, can be interpreted as a decrease in the value of a unit of money.