In our earlier explanation of supply and demand, we focused on how these forces set the price of a product in a market. Now, let’s add a deeper layer: the role of money.
1. Money as a Measure of Value
Money is the common tool used to measure the value of goods and services. When you buy something, you're exchanging a certain amount of money for that product, reflecting its value in monetary terms.
But money itself, like any other good, has its own supply and demand factors.
2. Money Supply and Demand
Just as with products:
When the supply of money increases relative to demand, the value of money decreases.
When the supply of money decreases, or if demand for money increases (say, due to higher interest rates or tighter credit), the value of money increases.
3. How Money is Created
In modern economies, most new money is created through credit. Banks issue loans, which puts more money into the economy. For example:
When a bank loans money to a business or an individual, that loan creates new money. The person spends that money, circulating it in the economy.
When interest rates are low, it's cheaper to borrow, so more people and businesses take out loans. This increases the money supply.
4. Inflation
When the supply of money grows faster than the supply of goods and services, each unit of money becomes worth less. This phenomenon is called inflation.
Inflation doesn't necessarily mean the value of products has increased, but rather that money has lost its value. As a result, you need more money to buy the same product.
So, inflation raises prices across the board, even if the supply and demand for individual products haven’t changed.
Example:
Let’s go back to the smartphone example:
The price of the smartphone might stay stable at $1,000.
But if the central bank increases the money supply by lowering interest rates, the purchasing power of money declines.
After inflation, that same smartphone might now cost $1,100. However, it’s not that the smartphone has become more valuable; it's that the money used to buy it has lost value, so more dollars are needed to buy the same phone.
5. Interest Rates and Money Supply
Interest rates play a crucial role in controlling the money supply:
Lower interest rates make borrowing cheaper, encouraging more loans and increasing the money supply. This often leads to inflation, as more money chases the same amount of goods and services.
Higher interest rates make borrowing more expensive, reducing the money supply, which can slow inflation or even cause deflation (when prices fall because money becomes more valuable).
6. Distinguishing Price Changes Due to Inflation vs. Supply and Demand
If the price of a product rises due to a change in supply and demand, it means the market for that specific product is adjusting (e.g., higher demand or lower supply pushes prices up).
If the price rises due to inflation, it means that the increase is caused by the devaluation of money, not because of changes in the product's inherent value or market demand.
Summary:
Money is used to measure value, but its own value fluctuates based on supply, demand, and interest rates.
Inflation happens when more money is created (usually through credit), leading to a general rise in prices, not because products are becoming more valuable, but because money is losing value.
Interest rates influence the supply of money: lower rates increase money supply (boosting inflation), and higher rates reduce money supply (potentially lowering inflation).
Understanding this dynamic helps you see that rising prices don’t always reflect a product becoming more valuable—it often reflects the declining value of money.