Money Mischief_ Episodes in Monetary History - Milton Friedman [15]
We are now back to our earlier problem. To each individual separately, it looks as if he can consume more by reducing his cash balances, but the community as a whole cannot do so. Once again, the helicopter has changed no real magnitude, added no real resources to the community, changed none of the physical opportunities available. The attempt of individuals to reduce their cash balances will simply mean a further bidding up of prices and income, so as to make the nominal stock of money equal to one-twelfth instead of one-tenth of a year's nominal income. Once that happens, prices will rise by 10 percent a year, in line with the increasing amount of money. Since both prices and nominal income will be rising at 10 percent a year, real income will be constant. Since the nominal quantity of money is also rising at 10 percent a year, it stays in a constant ratio to income—equal to 4⅓ weeks of income from the sale of services.
Attaining this path requires two kinds of price increase: (1) a once-and-for-all rise of 20 percent, to reduce real balances to the level desired when it costs 10 cents per dollar per year to hold cash; (2) an indefinitely continued inflation at the rate of 10 percent per year, to keep real balances constant at the new level.
Something definite can be said about the transition process this time. During the transition, the rate of inflation must average more than 10 percent. Hence, inflation must overshoot its long-term equilibrium level. It must display a cyclical reaction pattern. In Figure 2, the horizontal solid line is the ultimate equilibrium path of inflation. The three broken curves after t0, the date at which the quantity of money starts to rise, illustrate alternative possible transitional paths: curve A shows a single overshooting and then a gradual return to the permanent position; curves B and C show an initial undershooting, then an overshooting, followed by either a gradual return (curve B) or a damped cyclical adjustment (curve C).
Figure 2
The necessity for overshooting in the rate of price change and in the rate of income change (though not necessarily in the level of either prices or income) is, I believe, the key element in monetary theories of business cycles. In practice, the need to overshoot is reinforced by an initial undershooting (as in curves B and C). When the helicopter starts dropping money in a steady stream—or, more generally, when the quantity of money starts unexpectedly to rise more rapidly—it takes time for people to catch on to what is happening. Initially, they let actual balances exceed long-run desired balances, partly out of inertia; partly because they may take initial price rises as a harbinger of subsequent price declines, an anticipation that raises desired balances; and partly because the initial impact of increased money balances may be on output rather than on prices, which further raises desired balances. Then, as people catch on, prices must for a time rise even more rapidly, to undo an initial increase in real balances as well as to produce a long-run decline.
While this one feature of the transition is clear, little can be said about the details without much more precise specification of the reaction patterns of the members of the community and of the process by which they form their anticipations of price movements.
One final important detail. Implicitly, we have been treating the real flow of services as if it were the same on the final equilibrium path as it was initially. That is wrong, for two reasons. First, and less important for our purposes, there may be permanent distributional effects. Second, and more important, real cash balances are at least in part a factor of production. To take a trivial example, a retailer can economize on his average cash balances by hiring an errand boy to go to the bank on the corner to get change for large bills tendered by customers.