When people today talk about the cost of money, what they are generally referring to is the interest rate charged by lenders for borrowed funds. Yet this is fundamentally incorrect, for the “price” or “cost” of money is nothing more than the quantity of goods or services that someone is willing to exchange for dollars. Consumers demand money for its essential function as the generally accepted medium of exchange and its intrinsic ability to be traded against all other goods and services, but money too is a good with widespread utility that is bought and sold on the open market similar to any other marketable commodity.
Society today, by way of law and custom, has come to think of virtually everything that can be purchased as being priced in terms of money. Yet when a person sells a good or service in a modern economy, they have effectively purchased money for the cost of the good or service they have provided in return. For example, if it can be said that a consumer pays $4 to an egg farmer for a dozen eggs, it can equally be said that the egg farmer has purchased $4 for the cost of 12 eggs. Or said in another way, the egg farmer can be said to have purchased $1 for the cost of 3 eggs. Similarly, if a consumer purchases a steak dinner for $20, it can also be said that the restaurant has purchased $20 for 1 steak dinner. Or said in another way, the restaurant has effectively purchased $1 for 1/20th of a steak dinner.
In the examples described above, it should be at once apparent why virtually no one today thinks of “purchasing” money using goods and services as a means of payment. After all, goods and services have but one “money-price”, while money has many different prices when expressed in terms of all possible goods and services within an economy. And yet in trying to understand exactly how the demand for money influences its relative value, it is necessary first to consider the price of money in terms of other commodities.
Suppose, for example, that our egg farmer from the previous example, who was in the first place willing to trade 3 eggs for $1, begins to value money less such that he is now only willing to pay 2 eggs for $1. To the consumer of eggs, this now means that his $1 buys him only 2 eggs where it before bought him 3. Said in another way, a dozen eggs will now cost him $6 where it had previously cost him $4. Conversely, if the egg farmer begins to value money more, he may suddenly be willing to pay 4 eggs for $1, where previously he was only willing to pay 3 eggs. In this case, a dozen eggs will now cost the consumer $3 where previously it would have cost him $4.
Thus, in a high-inflation environment where people begin to lose faith in the generally accepted medium of exchange, the demand for money falls as people begin to value goods and services relatively more. The result is that they are willing to exchange less goods and services for the same quantity of money, causing the money-price of these goods and services to correspondingly rise. The opposite is true in a deflation. As people begin to assign more value to the embedded optionality of cash and its ability to hedge against future uncertainty, they become willing to exchange more goods and services for the same amount of dollars. Thus, the dollar price of goods and service correspondingly falls as the demand for money increases throughout society.
The confusion over what money “costs” is rooted in the fact that while all other goods and services have only a single dollar-price, money has many different prices. Given that the price of money is simply what others are willing to pay for it in terms of goods and services, this is simply another way of saying that the price of money is merely its average purchasing power, nothing more, nothing less.