Two Values of Money
Definition
Internal value of money: the domestic purchasing power of a currency, or the quantity of goods and services a unit of it buys at home.
External value of money: the value of a currency against others, measured by its exchange rate.
- Money has two values: what it buys at home and what it is worth abroad.
- Persistent inflation tends to weaken both, though not always at the same speed.
- The two are linked through competitiveness, capital flows and the exchange rate regime.
Key Idea
- Internal value is what money buys at home and is eroded by domestic inflation.
- External value is what the currency is worth abroad, measured by its exchange rate.
How the Two Values Are Linked
- Higher domestic inflation directly erodes the internal value, so each £1 buys fewer goods.
- If inflation exceeds that of trading partners, exports become dearer and imports relatively cheaper, cutting competitiveness.
- Weaker competitiveness lowers demand for the currency on the foreign-exchange market, so its external value tends to fall.
- The link runs in reverse too: a lower external value raises import prices, adding to inflation and further eroding the internal value.
Example
- Suppose the price level rises 25% over a period, so a basket that cost £100 now costs £125.
- Each unit of currency now buys only 80% of what it did, so the internal value has fallen 20%, the erosion inflation causes at home.
- In the extreme, Zimbabwe's 2008 hyperinflation saw prices roughly double every day, so the internal value of the Zimbabwe dollar collapsed and its external value fell just as fast, until the currency was abandoned in 2009 in favour of the US dollar and the South African rand.
Why the Relationship Is Not Automatic
Definition
Purchasing power parity: the theory that exchange rates adjust over the long run so that a given sum buys the same basket of goods in every country.
Hot money: short-term capital that moves between countries chasing the highest interest rate or expected currency gain.
- Purchasing power parity predicts that higher-inflation currencies depreciate in the long run, but it holds only loosely and slowly.
- In the short run, a central bank raising interest rates can attract hot money inflows, lifting demand for the currency and holding its external value up despite inflation.
- Under a fixed or managed exchange rate, the authorities buy their own currency using reserves to hold the external value steady even as the internal value falls.
Note
- Internal value affects living standards at home, while external value affects trade and import prices.
- Persistent inflation tends to weaken money on both fronts, but capital flows and the exchange rate regime can delay or offset the fall in external value.
Does higher inflation always weaken a currency's external value?
- Over the long run it usually does: if a country's inflation runs above its trading partners', its exports lose price competitiveness and demand for the currency falls, so purchasing power parity predicts a depreciation.
- But the link is loose and slow: a central bank that raises interest rates can pull in hot money and prop the currency up, and under a fixed or managed regime the authorities can defend the external value with reserves even while the internal value erodes.
- On balance, whether the external value falls depends on the exchange rate regime, relative interest rates and the time horizon: over several years purchasing power parity tends to pull the currency down, but over months capital flows and policy can dominate, so inflation is a tendency towards depreciation rather than a guarantee.
Exam technique
- Define internal value as domestic purchasing power and external value as the exchange rate.
- Explain both directions, showing how inflation erodes internal value and can lower external value.
- Use relative inflation and purchasing power parity to reach a supported judgement.
Common Mistake
- Do not confuse the internal value with the external value of money.
- Do not assume inflation always lowers the exchange rate, because high interest rates or a fixed regime can hold it up.
Self review
- What is the internal value of money?
- What is the external value of money?
- How does inflation erode the internal value?
- How can higher relative inflation lower the external value?
- Why might the exchange rate not fall despite high inflation?
