Money Mischief_ Episodes in Monetary History - Milton Friedman [12]
Reconciling Supply and Demand
We have come a long way from our initial simple question: what determines how much we can buy with the greenbacked five-dollar bill we started with? We are ready to return to that question by putting together the two blades of the monetary scissors, supply and demand.
In our hypothetical world in which paper money is the only medium of circulation, consider first a stationary situation in which the quantity of money has been constant for a long time, and so have other conditions. Individual members of the community are subject to enough uncertainty that they find cash balances useful to cope with unanticipated discrepancies between receipts and expenditures. But these uncertainties average out, so that the community as a whole wishes to hold as cash balances an amount equal to one-tenth of a year's income.
Under those circumstances, it is clear that the price level is determined by how much money there is—how many pieces of paper of various denominations. If the quantity of money had settled at half the assumed level, every dollar price would be halved; at double the assumed level, every pricewould be doubled. Relative prices would be unchanged.
This very hypothetical and unreal situation, from which we shall shortly depart, brings out sharply one special feature of money: its usefulness to the community as a whole does not depend on how much money there is. For almost all goods and services, the utility derived from them depends on their physical quantity, on the number of units. For money, it does not. Doubling or halving the number of dollars simply means that the numbers written on price tags are doubled or halved. When gold ruled the monetary roost, there was much talk about whether there would be enough gold to serve as monetary reserves. That was the wrong question. In principle, one ounce would be enough. It would not physically circulate, as most gold did not, but claims to it could be issued in any fractional denominations—for example, one-billionth of an ounce—that were convenient.
The reason it was the wrong question is that no important or interesting issues of monetary theory arise in the hypothetical situation of constant demand and supply. As David Hume wrote more than two centuries ago, "it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity" ([1742] 1804b, p. 305). As he also said, what matters is changes in the quantity of money and in the conditions of demand for money.
Let us suppose, then, that one day a helicopter flies over our hypothetical long-stationary community and drops additional money from the sky equal to the amount already in circulation—say, $2,000 per representative individual who earns $20,000 a year in income.* The money will, of course, be hastily collected by members of the community. Let us suppose further that everyone is convinced that the event is unique and will never be repeated.
To begin with, suppose further that each individual happens to pick up an amount of money equal to the amount he or she already holds, so that all find themselves with twice the cash balances they had before.
If everyone simply decided to hold on to the extra cash, nothing more would happen. Prices would remain what they were before, and individual incomes would remain at $20,000 per year. The community's cash balances would be 10.4 weeks' income instead of 5.2.
But people do not behave in that way. Nothing has occurred to make it more attractive for them to hold cash than it was before, given our assumption that everyone is convinced