# If I shred a $20 bill, is society poorer? What is the effect on the real economy? If the answer is yes, society is poorer, then the converse must hold true: that the government could make us all wealthier by simply printing money. However, a collapse in the money supply must have an effect on the real economy. One less Chipotle burrito gets sold. More formally, Milton Friedman's entire thesis was that a collapse in the money supply caused the Great Depression. Which is it, yes or no? And what are its reverberations throughout the "real" economy? • One thing to think about are the psychological externalities, for which there is no universal quantification, there is only survey data. Is the satisfaction you get from ripping apart a 20-dollar bill itself worth the 20 dollars that you might have otherwise spent on some other form of entertainment or the positivity of giving it to someone less fortunate, or for that matter, the diminishing returns of having$20 to rip apart in the first place? – JRRs Oct 5 '20 at 5:18
• Excellent point - although that logic might take you some places you don't want to go... For my purposes, let's assume I'm agnostic to the intrinsic utility of shredding it. My question was asking how a change in the money supply affects real "wealth" in the economy. Specifically in this example, as well. Not just abstractly. – Davis Clute Oct 5 '20 at 6:34
• Kudos for fighting inflation! – VARulle Oct 5 '20 at 7:41

You have to make distinction between short-run and long-run.

Short-run: In short-run money is not neutral, meaning that in short-run money and other nominal variables can affect real output. A one example why this is true are sticky wages. In presence of sticky wages wages (for example due to nominal contracts that take time to renegotiate) a fall in money supply and deflation would lead to increase in real wages above the equilibrium level. This would cause excess unemployment and loss of output until wages would finally adjust.

So in short-run amount of money and nominal variables in general have a real effect on economy although this effect is not as simple and clear cut as saying that shredding one bill will lower output and printing one more will increase it as the effect of changes in money supply depend on macroeconomic conditions (for example at zero lower bound increases in money supply will be mostly offset by drop in velocity of money see Krugman; 1998). However, discussing fully the reverberations money have in the short run is beyond the scope of SE answer. I recommend having look at Blanchard et al. Macroeconomics: an European Perspective chapters 3-10, 20-22 and 24 with emphasis on chapters 3-10 which have the core.

Long-run: In the long-run you get the classical dichotomy and money are neutral. This is almost definitional since long-run is in macroeconomics defined as a long period of time where among other things prices have time to adjust and are flexible.

This can be best seen from the AS-AD diagram below that I took from Mankiw's Principles of Economics:

As you can see short-run aggregate supply is increasing in aggregate price level so money are not neutral and can affect the level of production. However, the long-run aggregate supply is orthogonal on price level. No matter what the aggregate price level is the production will be always same and determined by the production possibilities of an economy (i.e. determined by real factors that affect the production possibilities of an economy).

This is intuitive as economy ultimately cannot produce more than it is possible given its production function and resource constraints. If an economy faces following production function $$F(L) = 5\sqrt(L)$$ and we have $$100$$ units of labor then we cannot produce more than $$50$$ units of output no matter how much money we print or destroy. Volume of money in circulation in the long-run does not make factors of production more productive nor it increases the stocks of factors production so by itself it can’t change how much economy can produce in the long-run.

• I appreciate the thoughtful answer and think the long/short run distinction is a good one. I just downloaded the textbook you suggested. While too long for this post, I am curious WHY nominal money growth (or shrinkage) would affect real output. While I see your point about sticky contracts, wages, prices, etc -- I would think/hope there is a more philosophically robust explanation of why money has such a strong (?) effect on real output -- rather than it just being due to pragmatic (i.e. frictional) hang-ups... – Davis Clute Oct 6 '20 at 0:56
• @DavisClute you are welcome. Also I would not minimize these frictional problems they are actually solid explanations that in modern AS-AD models are not just assumed like in vintage old Keynesian models. In modern models price rigidity is a result of rock-solid micro foundations (explicit models of costs to negotiation or switch in prices) and these nominal rigidities are further empirically tested and verified. I think that the price/wage rigidities are from scientific perspective as robust as possible. Aside from the above imperfect competition and market power also leads to non-neutrality – 1muflon1 Oct 6 '20 at 1:04
• Of money in the short run (see Romer Advanced Macroeconomics). Furthermore, some policy choices such as minimum wages can also create non-neutrality. There are also behavioral arguments for non-neutrality put forward (for example Friedman blamed money illusion - but these theories are actually less rigorous than the sticky wages/prices theory even if the story might be more appealing to layperson). Also I did not choose the example with sticky prices in the answer haphazardly that’s probably the most solid explanation theoretically and empirically we have. – 1muflon1 Oct 6 '20 at 1:08
• Funny you say behavioral, because I almost wrote "...due to psychological hang-ups" -- haha. And agreed on minimum wage laws being non-neutral vis-a-vis money/output. Will check out the Romer book. Good point on negotiations + switch in prices. Let me reflect on all of this... – Davis Clute Oct 6 '20 at 1:16
• @DavisClute oh and I also almost forgot in addition to the above there is also an argument put forward by Bernanke (based on old ideas of Fisher) about deflation causing credit crunch as banks might be less willing to lend to households/firms who’s real liabilities rise - again violating money neutrality in short term. Although this explanation is mostly put forward as an explanation for financial recessions. – 1muflon1 Oct 6 '20 at 1:22

The weak point of your logic is basing it on what happens to a \$20 bill. You can destroy such a bill, or the government can print such a bill, and it seems exceedingly likely that nothing measurable would happen to the aggregate economy. If we cannot measure the difference, we cannot say anything happened. (One can put forward theories about effects, but the theoretical change would not show up in observed data, and so there is no way of validating any theory.) We need to have a policy that has a measurable effect. Is it likely that a large number of people would simultaneously shred \$20 bills? This seems unlikely (but you never know).

Otherwise, we need a policy that can add or subtract money from many households. Fiscal policy does exactly this - taxes remove financial assets from the private sector, and spending injects financial assets.

In a recession, any Keynesian school of thought agrees that loosening fiscal policy will utilize more resources if interest rates are zero. The only debates happen when interest rates are non-zero, but that debate is too large to discuss here. 1muflon1’s answer discusses this topic in more depth.

To understand inflation or deflation you need a financial model like this for each economic unit:

NW = K + FA - L

Net worth equals the valuation of non-financial assets K plus financial assets FA minus liabilities L.

Next you need a model for direct lending by wealthy households to the working class households and/or a model for wealthy households lending to the working class via financial intermediaries. If no units issue liabilities then no other units hold financial assets, there is no money in the society, and there is no money value assigned to net worth. Economists refer to the zero net worth world as real income or real economic value because you would still prefer to live in a house and the value of living in the house provides economic income over time.

In theory transactions to increase economic value could proceed without the customs that generate or destroy financial assets and matching liabilities of some other unit, but in practice, the price mechanism is used and this depends on the creation or destruction of credit and debt using the definition of the money unit to make finance contracts and clear payment for goods, services, and satisfaction of credit terms. A rampant inflation or deflation would ensue when the credit system is not in good coordination with the production capacities of the economy.

In terms of macroeconomic psychology if we write down the debts of the working class then the wealthy would write down the value of financial assets. This would force the working class to transfer collateral held as nonfinancial assets to the balance sheets of the creditor class. The combination of credit rationing and the transfer of nonfinancial assets from debtors to creditors is a property of recessions and great depressions. There is no long run equilibrium because those who make credit extension or credit rationing or spending decisions do so in real time as conditions change in the economy. There is only a short run decision and action mechanism generating a new transitory response to credit conditions.