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In some ways, the value of money is simple to understand. Since money is just a medium of exchange, it’s worth whatever you can exchange it for. In other words, money is worth what it will buy.
Given economic factors like inflation, interest rates, and others, money’s value can also be complex.
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- How does money have value?
- How to measure the value of money
- 4 factors that can affect money’s value
- What’s next: Leverage your money’s value through investing
How does money have value?
In general, there are two types of money in the world: commodity money and fiat money. Each can be valuable for different reasons.
Commodity money
Commodity money is money with intrinsic value. In other words, it has value built in because of what it is. While commodity money has the advantage of being valuable by nature, it also comes with a few drawbacks.
- Fluctuating supply can impact purchasing power. In 19th century America, gold was one commodity accepted as money. Gold discoveries in Alaska and California dramatically increased the gold supply, leading to some of the worst inflation in American history.
- People’s desire to keep high-quality commodities could lead to only trading low-quality commodities. For example, in colonial New England, someone might enter into a loan agreement by promising to pay it back in an agreed-upon number of horses. However, they may pay back the loan unfairly by offering up one of their unhealthy horses instead of a healthy one.
Fiat money
Fiat money is money that does not have intrinsic value. Instead, it has value because of the trust people put in it to exchange goods and services, often by decree of a government authority.
The U.S. dollar is an example of fiat money. The paper itself may not provide much value, but because others will accept it to trade commodities, you value it nonetheless.
Often, fiat money is seen as valuable so long as it is stable. For example, when Russia printed too many rubles in 1990, the increased supply ultimately devalued the ruble. Russian citizens responded by switching to the U.S. dollar as their medium of exchange despite the ruble still being Russia’s officially decreed currency.
How to measure the value of money
Ultimately, the value of a dollar can be seen as what it will buy — or its purchasing power. This breaks down into domestic and international purchasing power, both of which have different measuring systems to help consumers understand the dollars’ worth.
Image: tools-to-estimate-dollars-worthDomestic purchasing power: CPI
A dollar’s worth when making purchases within the U.S. is directly related to inflation. The dollar cannot buy as much when goods go up in price.
Because of this relationship, it can be helpful for consumers to understand how much their money is worth today by looking at indexes that measure inflation, such as the Consumer Price Index.
The CPI is an index that measures price changes in goods like food, energy and medical services. If the CPI rises, your dollar is worth less.
International purchasing power: Exchange rates
When measuring a dollar’s worth internationally, looking at foreign exchange rates can be helpful. These rates tell you how many units of foreign currency each dollar is worth. The more you can receive for one dollar, the more purchasing power you’ll have abroad — and vice versa.
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4 factors that can affect money’s value
Money doesn’t always have the same purchasing power. In other words, one dollar might be worth more or less depending on a combination of economic factors. Here are a few factors that can determine the value of money.
Image: factors-that-affect-moneys-value1. Inflation
Inflation occurs when the price of goods and services increases over a period of time. A fun way to understand inflation is by looking at the Big Mac index, which measures Big Mac prices over time.
When McDonald’s released the Big Mac in 1967, it cost only 45 cents. As of June 2023, the burger runs about $5.58 —, meaning its price has increased more than 12 times.
Of course, our wages aren’t the same today as in 1967. The median annual household income in 1967 was only $7,200. According to the most recent data from the U.S. Census Bureau’s Current Population Survey, the median annual household income in 2021 was $70,824.
2. Deflation
While inflation happens when prices rise, deflation happens when prices fall. In an economy experiencing deflation, the value of its dollar increases. Lower prices mean you can buy more.
Deflation can lead to less spending since people may wait to see if prices fall further before purchasing — exactly what happened in Japan’s deflated economy during the 1990s and 2000s. Deflation may also lead to fewer available jobs and even a recession.
3. Interest rates
Interest rates can be considered the amount it costs to borrow money. Higher interest rates make borrowing money more expensive, while lower interest rates lessen the cost and usually spur more borrowing.
However, the relationship is typically reversed when it comes to foreign exchange trading: Lower interest rates lead to less demand for a currency, and higher interest rates lead to increased demand.
The reason for this is found in supply and demand. When a country offers a higher interest rate, it promises higher financial returns. Therefore, demand will increase, supply will decrease (fewer traders holding the currency have an incentive to sell), and the currency will appreciate.
4. Real GDP
Another factor that can affect foreign exchange rates is a country’s gross domestic product (GDP). If a country experiences economic growth resulting in a higher real GDP, that country will have more currency to trade on the foreign market.
For example, an increase in the U.S. GDP would lead to more U.S. dollars in supply. This increased supply would lead to dollar depreciation in the foreign market unless demand for the dollar outpaced the increased supply.
What’s next: Leverage your money’s value through investing
It may be wise to begin investing as soon as possible to reap the benefits of compounding interest. Keeping your money in a simple savings account might not keep pace with inflation, meaning you could lose purchasing power over time.
On the other hand, investing in the S&P 500 has average returns of around 11.5% since 1928, more than enough to outpace inflation on average.
If you’re investing to fund a retirement account, remember to include the effects of inflation in your plan. Using a retirement calculator to see your retirement savings progress may be a good idea.
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