We will start our analysis of the effects of an expanding money supply with a model that is purely a mental construct. It is a simple thought experiment that was famously used by David Hume about 250 years ago in his essay “Of Interest.”1
Even, Instant, and Transparent Money Injection
Let us assume that a money producer increases the individual cash balances of every person in society through an act of magic by exactly 10 percent overnight. If a person had $1,000 in money the evening before, that person will now have $1,100 in money holdings. A person who had $50 in money will now have $55. The overall amount of money in the economy thereby increases by 10 percent but, importantly, this happens instantaneously, with everybody affected at the same time and in exactly the same way. This is a one-off event; no additional money injections follow. We will make one additional assumption: Every person, as he wakes up and goes about his business, not only knows immediately that he magically received an additional 10 percent of cash, but he also knows that everybody else has received an additional 10 percent of their previous money holdings, too.
This is, of course, a most unrealistic example of money injections. However, we can quickly see that this fantastical scenario is the only one imaginable, in which the increased supply of money affects the price level only and does so in a way that is exactly proportional to the change in the ...