Money Mischief_ Episodes in Monetary History - Milton Friedman [9]
The Demand for Money
The Federal Reserve can determine the quantity of money—the number of dollars in the hands of the public. But what makes the public willing to hold just that amount, neither more nor less? For an answer, it is crucial to distinguish between the nominal quantity of money—the number of dollars—and the real quantity of money—the amount of goods and services that the nominal quantity will purchase. The Fed can determine the first; the public determines the second, via its demand for money.
There are many ways to express the real quantity of money. One particularly meaningful way is in terms of the flow of income to which the cash balances correspond. Consider an individual receiving an income of, say, $20,000 a year. If that individual on the average holds $2,000 in cash, his cash balances are the equivalent of one-tenth of a year's income, or 5.2 weeks of income: his cash balances give him command over the quantity of goods and services that he can buy with 5.2 weeks' income.
Income is a flow; it is measured as dollars per unit of time. The quantity of money is a stock, not in the sense of equity traded on an exchange but in the sense of a store of goods or inventory, by contrast with a flow. Nominal cash balances are measured as dollars at a point in time—$2,000 at 4:00 P.M. on July 31, 1990. Real cash balances, as just defined, are measured in units of time, like 5.2 weeks; "dollars" do not enter in.*
It is natural for you, as a holder of money, to believe that what matters is the number of dollars you hold—your nominal cash balances. But that is only because you take dollar prices for granted, both the prices that determine your income and the prices of the things you buy. I believe that on reflection you will agree that what really matters is your real cash balances—what the nominal balances will buy. For example, if we expressed nominal magnitudes in cents instead of dollars, both nominal income and nominal cash balances would be multiplied by 100, but real balances would be unaffected, and it would make no difference to anyone (except those who had to write down the larger numbers).
Similarly, try to conceive of every price, including those that determine your income, being multiplied by 100 overnight—or divided by 100—and, correspondingly, your cash balances, nominal debts, and nominal assets being simultaneously multiplied or divided by 100. Nothing would be really changed. Of course, that is not the way changes in the quantity of money or in prices generally come about, which is what raises all the difficulties in monetary analysis. But it is what happens when a government, typically during or after a major inflation, announces a so-called monetary reform that substitutes one monetary unit for another. It is what, for example, General Charles de Gaulle did in France on January 1, 1960, when he replaced the then franc with the nouveau franc, or new franc, by simply striking two zeros from all calculations in the old franc. In other words, 1 new franc equaled 100 old francs. De Gaulle made this change as part of an extensive monetary and fiscal reform that did have significant effects, though the mere change of units did not. However, the episode is another instance of how deeply embedded are public attitudes to money. For decades thereafter, many French residents continued to express prices and perform monetary calculations in old francs, striking off the final two zeros only when offered payment in nouveau francs.
When such alterations of monetary units are combined with superficial monetary and fiscal changes, as when Argentina in 1985 replaced the peseta with the austral, they have at most had highly temporary and minor effects, because they do not by themselves alter real magnitudes.