Both these terms seem identical. However, they are entirely different concepts. Let us discuss the various distinctions between these two terminologies:
Table Of Contents
Numéraire Definition
Numéraire refers to a price measurement unit and is considered a base value against which the prices of other similar products and services are assessed and compared. It sets the standard or becomes the benchmark for pricing goods and services, as well as financial instruments in the market.
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Numéraire is a French term that means face value, money, or coinage. In economics, the value of a good is generally fixed and can never be zero since it is used to normalize the other relative product prices. Also, such a commodity should be highly liquid and tradable in the financial markets to be recognized as a numéraire good or product.
Key Takeaways
- Numéraire is a French word that refers to the base value or unit of measurement or common denominator used to express and compare the values of similar goods or financial instruments.
- It facilitates economic analysis by gauging the change in relative prices of goods and assets across the market or index.
- To qualify as a numéraire, a good should be highly liquid, extensively tradable, easily divisible, and must have maintained stable prices over the period.
- The US dollar is recognized as a numéraire worldwide for determining the prices of various commodities.
Numéraire Explained
Numéraire is particularly relevant in general equilibrium theory, where it helps in understanding the relative prices of various goods, services, financial instruments, and factors of production. For instance, in macroeconomic analysis, a country's domestic currency is commonly used as the numéraire. Economists can analyze relative price changes, inflation rates, and other macroeconomic variables by expressing the values of goods, services, and assets in terms of a common currency.
The floating exchange rates were introduced in 1973, resulting in the end of the Bretton Woods System, which was widely accepted since 1944 for determining numéraire based on fixed exchange rates. In this system, the value of gold was the standard for pricing the US dollar, which served as a benchmark for pricing the other currencies. But at present, the currencies float against each other in the forex market, thus making it a highly volatile commodity.
The choice of numéraire is arbitrary, as any good or asset can be a reference point. However, it should possess certain traits to be qualified as an effective numéraire. Such a good should be widely traded, and its value should be easily divisible, allowing for accurate price observations and comparisons across the market or index. Additionally, it should maintain a relatively stable value over time to minimize distortions in price comparisons. Finally, such a good shouldn't provide any scope for arbitrage.
History
In ancient times, when there were no currencies, the barter system was based on numéraire, where the value of one commodity determined the value of other commodities, goods, or services.
Throughout history, precious metals like gold have functioned as numéraire in various economic systems. Their rarity, durability, and intrinsic value have made them popular for storing wealth and as a standard against which other goods and assets are priced. Before 1973, even the US dollar was valued against the gold price.
Examples
Let us consider the following examples to understand the concept and its significance better:
Example #1
Suppose there are only five goods in a market: A, B, C, D, and E. Among these, only A and D were found suitable for numeraire to be applicable as they fulfilled all traits of becoming a product, the pricing of which could set a standard to compare other similar goods in the market. However, when the historical price trends were analyzed, it was found that product A has been witnessing unstable fluctuation in its pricing. In contrast, D's pricing remained stable for more than a decade. Hence, D was chosen as a numéraire good, and the values of all the other goods, i.e., A, B, C, and E, were compared against its value to understand the change or price trend.
Example #2
The Consumer Price Index (CPI) is often employed as a numéraire in macroeconomics to gauge inflation. It represents the average price level of a basket of household goods and services. Changes in the CPI over time indicate the rate of inflation or deflation.
Example #3
Money is the most widely used numéraire in everyday economic transactions. It acts as an exchange medium, a store of value, and a unit of account. Goods and services are typically quoted in a specific currency, such as the United States Dollar (USD) or the euro. The USD is a globally recognized numéraire since the prices of most commodities are determined against the value of USD.
Numéraire vs Numeraire
| Basis | Numéraire | Numeraire |
|---|---|---|
| 1. Definition | A numéraire serves as a unit of measurement used to express prices and values relative to other goods within an economic system. | A numéraire serves as a unit of measurement used to express prices and values relative to other goods within an economic system. |
| 2. Field | Economics | Economics |
| 3. Function | Serve as a base value, reference point, benchmark, or standard for comparing and valuing different economic variables. | Serve as a base value, reference point, benchmark, or standard for comparing and valuing different economic variables. |
| 4. Significance | It is widely used for economic analysis. | It is widely used for economic analysis. |
| 5. Selection | The selection is subjective and can vary based on the specific context and economic model utilized. | The selection is subjective and can vary based on the specific context and economic model utilized. |
Frequently Asked Questions (FAQs)
1
Why is the numéraire important?
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What is numéraire goods in general equilibrium?
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What is numéraire in option pricing?
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What is the change of numéraire currency?
