Money Mischief_ Episodes in Monetary History - Milton Friedman [16]
Our simple hypothetical helicopter example brings out clearly a phenomenon—some might call it a paradox—that is of the utmost importance in the actual course of events. To each individual separately, the money from the sky seems like a bonanza, a true windfall gain. Yet when the community has adjusted to it everyone is worse off in two respects: (1) the representative individual is poorer because he now has a reserve for emergencies equal to 4⅓ weeks' income rather than 5.2 weeks'; (2) he has a lower real income because productive resources have been substituted for cash balances, raising the price of consumption services relative to the price of productive services. This contrast between appearance to the individual and the reality for the community is the basic source of most monetary mischief.
The Famous Quantity Equation of Money
The preceding discussion can be summarized in a simple equation—an equation that was envisaged by scholars centuries ago, was stated carefully and precisely in the late nineteenth century by Simon Newcomb, a world-famous American astronomer who, on the side, was also a great economist, and was further developed and popularized by Irving Fisher, the greatest economist the United States has ever produced. In Fisher notation, the equation is
MV = PT.
M is the nominal quantity of money. As we have seen, it is currently determined in the United States by the Federal Reserve System. V is the velocity of circulation, the number of times each dollar is used on the average to make a purchase during a specified period of time. If we restrict purchases to final goods and services, and if the public holds 5.2 weeks of income in cash, as in our example, then the velocity is 10 times per year, since a year's income (equal to a year's purchases of final goods and services, which include savings) is ten times the quantity of money.* V is determined, as we have seen, by the public according to how useful it finds cash balances and how much it costs to hold them. The product of M and V, the left side of the equation, is total spending or income.
On the right side, P is an average price, or an index of the average price, of the goods and services purchased. T stands for transactions, to be interpreted as an index of the total quantity of goods and services purchased. Fisher, in his original version, used T to refer to all transactions—purchases of final goods and services (like bread purchased by the final consumer), intermediate transactions (flour purchased by the baker), and capital transactions (the purchase of a house or a share of stock). In current usage, the item has come to be interpreted as referring to purchases of final goods and services only, and the notation has been changed accordingly, T being replaced by y, as corresponding to real income.
As written, the equation is an identity, a truism. Every purchase can be viewed in two ways: the amount of money spent and the quantity of a good or service purchased multiplied by the price paid. Entering the amount of money on the left side and quantity times price on the right, and adding up those sums for all purchases, we have a standard case of double-entry bookkeeping. As in double-entry bookkeeping in general, the truism is highly useful.
Consider once more our original question: What determines how much you can buy with the greenbacked five-dollar bill we started with? Nothing can affect P except as it changes one or more of the other items in the equation. Will a boom in the stock market, for example, change how much you can buy with a five-dollar bill? It will reduce