Devaluing the Dollar

Thursday, September 23, 2010
By Paul Martin


There is regularly talk about the Fed (or Treasury) devaluing the US dollar, but how do you devalue something that doesn’t have a fixed measurement? Specifically, what would the Fed/Treasury devalue the dollar against and how would they go about it? In a recent interview with Eric King, Jim Rickards posits that the Fed could bring about a general dollar devaluation by using its open market operations to bid up the gold price, the idea being that devaluing the dollar against gold would scare people out of dollars and thus cause a reduction in the dollar’s purchasing power. Would this work?

Well, if the Fed started bidding up the gold price it would definitely scare a lot of people, but by itself it couldn’t bring about a sustained reduction in the dollar’s purchasing power. To explain why we first need to quickly revisit the over-used concept of money “velocity”.

When people talk about a change in money velocity what they really mean is a change in money demand. As is the case with the values of all economic goods, the value of money is influenced by changes in both supply and demand. For example, an increase in the supply of money wouldn’t lead to a fall in the value of money if it were offset by an equivalent increase in the demand for money (often described as a reduction in money “velocity”). For another example, a reduction in the demand for money (often described as an increase in money “velocity”) could bring about a reduction in money purchasing power (a general increase in prices) even if there were no change in money supply. However, whereas economic goods other than money are often subject to permanent changes in demand that are separate from (that is, not caused by) changes in supply, if the money supply is stable then changes in money demand will almost always be temporary. Consequently, it is not possible for a currency to experience hyperinflation, and it is extremely unlikely that a currency could experience a large and sustained reduction in its purchasing power, in the absence of a large increase in its supply.

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