Thursday, January 8, 2009

What is the Value of a Dollar Bill?

One of the failings of our culture is how often the voter is asked to make economic decisions, without first understanding basic economics. If you're one of those people, I heartily recommend Thomas Sowell's Basic Economics.

Here's my attempt to provide a foundational understanding of what is coming with the economy. We're in for an interesting currency ride, but to explain that, we have to go over what currency is worth.

Why do we pass paper around?

Paper money has no practical value of course. Coins have some practical value (you can use the metal for great projects like this one, or this one). The amazing thing that most people don't realize is that nothing has an inherent price. You set the value an egg or a pencil or a lamp when you decide to trade something you own for it.

Wealth is created every time a voluntary trade happens. If I trade my pencil for your egg, it means you value the pencil more than the egg, and I value the egg more than the pencil. We both win. But of course eggs and pencils aren't convenient to carry around. Paper and coin currency are more convenient, and have the additional advantage of being fungible (a fun word that means that any dollar bill is exactly the same as any other dollar bill).

Now it used to be the case that the dollar bill was tied to a quantity of gold. Even when you wrote a contract, you could required to be paid in "or the equivalent value of gold." The reason gold is used as a currency is:
  • it is stable - it doesn't react with other compounds, so it doesn't tarnish, etc.
  • it is easy to identify and verify as real
  • there is only so much gold in the world - you can't simply manufacture it
Even so, gold only has the value you think it does. An ounce of gold can be traded for whatever you want if you can get someone to agree to it. If you accept an ounce of gold for your refrigerator (the price for gold as I type this are about $855 / ounce), it's because you think someone else will take that ounce from you and give you something you value about the same as your refrigerator.

The same thing goes for dollars. You accept dollars in exchange for your stuff, because you expect to use those dollars to pay for something worth about the same as your stuff.

Next time: Deflation.


Soloist said...

OK this is clear that we use dollars (or any currency) for trade....but what decides the value of a dollar in international market and the value of gold in the same.

Soloist said...
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Mark said...

It's all about confidence. How much are people willing to buy dollars or yen or anything else for.

The coming post about Inflation will talk about how people lose confidence in currency.

Mark said...

Additionally, the world met in 1944 to decide the value of one ounce of gold at USD 35, and establish the US Dollar as the backbone of international currency.