What is money? This question might sound a little deep for Congress, but the topic was discussed today in a hearing on monetary policy. Its only witness was Federal Reserve Chairman Ben Bernanke. He endured a second day of questioning after testifying before the Senate on the same topic on Tuesday. But House members often pose more interesting questions, and due to his distaste for the Fed, Rep. Ron Paul (R-TX) tends to ask some of the best with Bernanke is in the hot seat. He wanted to know how Bernanke would define a dollar.
Those who follow politics probably know that Ron Paul staunchly opposes the Fed's control of money supply and argues that a gold standard would result in a more stable economy. It's quite easy to define a dollar in gold standard -- it's simply equivalent to some quantity of gold. In a system of paper money, where a central bank regulates monetary supply, however, the definition isn't as straightforward.
So after Paul used most of his time to voice his concerns about the general philosophy of inflationary monetary policy and his preference for a gold standard, he asked Bernanke for his definition of a dollar. Bernanke responded:
My definition of the dollar is what it can buy. Consumers don't want to buy gold; they want to buy food, and gasoline, and clothes and all the other things that are in the consumer basket. It is the buying power of the dollar in terms of those goods and services that is what is important, and that's what I call price stability.
To draw the analogy, under a gold standard a dollar is defined by how much gold it can buy. In the absence of a gold standard in the U.S., a dollar is defined by some quantity of goods within the basket used to determine consumer inflation.
This really isn't exactly right, however. Paul's question really deserves a more thoughtful response. The dollar isn't simply pegged to a basket of goods like it would be to gold under a gold standard. Instead, some low rate of inflation is targeted by the central bank, which is managed by considering the prices of goods in that basket.
The difference here is subtle but important. Under inflationary monetary policy, the dollar becomes worth less and less. So its value relative to that basket of goods is constantly changing. Its definition is a moving target.
To imagine a simplistic example, let's say our basket of goods consisted of apples, oranges, pears, and bananas. And let's say that they're all weighted equally. Let's also assume inflation is targeted to be 2% per year. Over the course of the year, let's say $200 can buy you 50 of each of the four fruits in the basket of goods. At year's end, that same $200 can only buy about 49 of each of those goods. So the amount of stuff in the basket has changed. The definition of $200 moved from 50 apples, oranges, pears, and bananas to 49 apples, oranges, pears, and bananas.
Compare that to a gold standard. Let's say at the beginning of the year, the price of gold is $1,000 per ounce. That's the same as saying that a dollar is worth one one-thousandth (1/1000) of an ounce of gold. At year's end, you can still buy the same amount of gold with your dollar, unless the definition has been changed by policymakers. It is possible, however, that you may be able to buy additional or fewer goods and services with that dollar, depending on how other factors in the economy have changed.
So Bernanke's definition of a dollar is constantly moving, while Paul's would be static. Which framework is better is a far more complicated and controversial question. We'll leave that for another time, but both methodologies have pros and cons.