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In the pure credit (cashless) economy, banks would face no such constraint
in the form of a limited stock of base money (gold coins for Wicksell) hence
no automatic equilibrating mechanism would exist. If banks maintained their
actual loan rate below the natural rate indefinitely, prices would rise without
limit through the cumulative process. No constraint would operate on the supply
of loans, since banks would not have to worry about losing gold reserves. No
constraint would operate on the demand for loans either, as long as the gap
between the actual and natural rate were maintained.
We add that the nominal demand for loans would keep growing not only
because of the interest rate gap, but also because of increased prices and expectations of further rises. Alluding to these expectations, Wicksell said (1898
[1936] [1965], p. 96): The upward movement of prices will in some measure
create its own draught.

HOW THE SUPPLY OF MONEY CREATES ITS OWN

DEMAND
A further appeal to the Wicksell Process explains how money initially in excess
supply can come to be fully demanded after all. The banking system as a whole
can expand credit and deposits so far as reserves permit.4 Nothing bars lending
and spending new demand deposits into existence. No one need be persuaded
to hold them before they can be created; no one will refuse money for fear of
being stuck with too much. A person accepts money not necessarily because
he chooses to continue holding it but precisely because it is the routine intermediary between his sales and his purchases or investments and because he
knows he can get rid of it whenever he wants. In contrast, people will not
accept noncheckable deposits or other nonmoneys that they do not desire to
hold, so undesired quantities of them cannot be created in the first place. And
if anyone did find himself somehow holding undesired nonmoneys, he would
simply cash them in for money if they were redeemable and so make them go
out of existence. He would still cash them even if he did not want to hold the
money received, since money is the intermediary routinely used in buying all
sorts of things.
A holder of undesired or excess money exchanges it directly for whatever he
does want, without first cashing it in for something else.5 Nothing is more
ultimate, more liquid, the bearer of greater options than money. Instead of going
out of existence, excess money gets passed around until through price and
income changes it ceases to be undesired. (An exception concerning fixed
exchange rates is developed later in this chapter and in Chapter 9.) Supply thus
creates its own demand (both expressed as nominal, not real, quantities). This

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proposition does not apply separately, of course, to each particular type of

money to currency of each particular denomination and to deposits at each
individual bank but rather to the medium of exchange in the aggregate.
Nor does the proposition imply that a demand function for money does not
exist nor that the function always shifts to keep demanded and actual quantities
not merely equal but identical. Rather, an initial excess supply of money touches
off a process, the Wicksell Process, that raises the nominal quantity demanded
quite in accordance with the demand function. At least two of its arguments
change: the money values of wealth and income rise through higher prices or
fuller employment and production, and interest rates may fall during the
transition process.
Initially excess cash balances burn holes in pockets, with direct or indirect
repercussions on the flow of spending in the economy. No such process affects
nearmoneys and other nonmoneys. For an ordinary asset, a discrepancy between
actual and desired holdings exerts direct pressure on its price (or yield or similar
terms on which it is acquired and offered). If the supply and demand for an
asset are out of balance, something has to give. If the something is specific
and gives readily, the adjustment can occur without widespread and conspicuous repercussions. But the medium of exchange has no single, explicit
price of its own expressed in a good other than itself that can give readily to
remove an imbalance between its supply and demand. Widespread repercussions occur instead. (Chapter 4 elaborates on the way an excess demand for a
nonmoney is removed or diverted, in contrast to an excess demand for money
that is neither removed directly nor diverted.)
Money is unique in the further sense that its equilibrium quantity is not
determined in the same way as for other goods. For most goods, like houses,
cars and refrigerators, supply and demand determine equilibrium quantity and
price both. However, the nominal quantity of money is determined predominantly on the supply side in the manner the textbooks describe in terms of the
quantity of base money and the money-multiplier formula. Even in the case of
interest rate pegging by the monetary authority, the nominal supply of money
does not adjust automatically to meet the nominal demand. Pages 11820
below explain why money demand may have to adjust to the supply in this
case. Real supply does tend to meet real demand through what we have called
the Wicksell Process.
Additional money can thus be thrust onto a country even without being
demanded. The reasons are moneys role as a medium of exchange, the lack of
a specific market for money, the buffer stock role of individual money holdings,
and the process whereby the nominal supply of money can create its own
demand. This process is compatible with and even presupposes a fairly definite
demand-for-money function.

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THE FUNDAMENTAL PROPOSITION AND THE

MONETARY-DISEQUILIBRIUM HYPOTHESIS
Through the Wicksell Process, incomes and prices adjust to make the total of
desired nominal cash balances equal the actual money stock. This process of
reconciling the demand for money with its supply is the theme of what Keynes
(1936, pp. 845) called the fundamental proposition of monetary theory and
Friedman (1959a [1969], pp. 1412) called the most important proposition in
monetary theory. In Keyness words, this proposition describes what:
harmonises the liberty, which every individual possesses, to change, whenever he
chooses, the amount of money he holds, with the necessity for the total amount of
money, which individual balances add up to, to be exactly equal to the amount of
cash which the banking system has created. In this latter case the equality is brought
about by the fact that the amount of money which people choose to hold is not independent of their incomes or of the prices of the things (primarily securities), the
purchase of which is the natural alternative to holding money. Thus incomes and
such prices necessarily change until the aggregate of the amounts of money which
individuals choose to hold at the new level of incomes and prices thus brought about
has come to equality with the amount of money created by the banking system. This,
indeed, is the fundamental proposition of monetary theory.

Similarly, Friedman states:

This essential difference between the situation as it appears to the individual, who can
determine his own cash balances but must take prices and money income as beyond
his control, and the situation as it is to all individuals together, whose total cash
balances are outside their control but who can determine prices and money income,
is perhaps the most important proposition in monetary theory...

According to the fundamental proposition, the demanded quantity of money

that aligns itself with the actual stock is expressed in nominal terms. For the real
(purchasing-power) quantity, the adjustment works the other way around: the
desired real quantity of money pulls the actual quantity into line.
The fundamental proposition holds true of the actual medium of exchange
only. Individual economic units are free to hold as much or as little of it as they
see fit in view of their own circumstances; yet the total of their willingly held
cash balances is identical with the money supply, which the monetary authority
can make as big or small as it sees fit. The process that resolves this paradox
has no counterpart for noncirculating claims on financial intermediaries;
undesired holdings simply go out of existence. The proposition also fails for
other nearmoneys, such as securities. But instead of shrinking in actual amount
to the desired level, an initially excessive quantity shrinks in total market value.

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Warburton expounds what he calls the monetary-disequilibrium hypothesis:

[B]usiness fluctuations are results of disturbance in the monetary system...a
potent cause of disequilibrium may be a change in the quantity of money. This
hypothesis was an integral...part of the body of economic thought developed
in the nineteenth century and the first quarter of the twentieth (1966, pp. 267).
When the money supply increases, prices or real income (or both) must rise. The
rise in prices makes the nominal quantity of money demanded expand to absorb
the increased supply. In real terms, the rise in prices arithmetically shrinks the
real money supply, bringing it back into line with real demand. If real income
rises instead of or along with prices, then both nominal and real quantities of
money demanded increase to absorb the supply. (Real income could expand
beyond the full-employment level only temporarily, as argued below.) Opposite
processes occur when the nominal money supply shrinks.

THE EXCEPTION UNDER FIXED EXCHANGE RATES

The fundamental proposition, or its simplest version, presupposes either a closed
economy or an open economy with a floating exchange rate. Things are different
if the monetary authority intervenes on the exchange market to fix the rate of
exchange between foreign and home money; for in buying and selling foreign
exchange, the authority is injecting home money into and withdrawing it from
circulation, much as it does when conducting open-market operations in
securities. The home money supply responds to balance-of-payments developments at the fixed exchange rate, and changes in the demand for money to
hold can cause supply to respond in nominal as well as real terms. This analysis
applies most straightforwardly to a national currency not used as an international
key currency. Because of the dollars special international role, the US monetary
system retained, even under fixed (pegged) rates, the essential domestic characteristics of a system with a floating exchange rate (see page 260 below).
Suppose, for example, that people come to desire larger money holdings than
before. The Wicksell Process operates as people try to build up their cash
balances by acting less eagerly to buy goods and services and securities and
more eagerly to sell. This changed behavior shows up partly at the waters edge:
domestic residents tend to develop an excess of sales over purchases in transactions with foreigners; the balance of payments moves into surplus; and, in
the process of buying up surplus earnings of foreign exchange to keep the
exchange rate fixed, the monetary authority puts additional home money into
circulation. In effect, domestic residents satisfy their increased demand for
money in both real and nominal terms by developing an excess of sales over
purchases in transactions with foreigners. Conversely, a reduced demand or a
domestically increased supply of home money gives rise to a balance-of-

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payments deficit at a fixed exchange rate, which tends to remove the excess
money from circulation.
Although changes in a countrys money supply associated with a payments
surplus or deficit at a fixed exchange rate may correspond to aggregates of
desired changes in individual holdings, it does not follow that the changes must
so correspond. Balance-of-payments disequilibrium may also trace to some circumstance other than excess demand for or supply of cash balances. In certain
circumstances, as history illustrates, foreign developments working through
the balance of payments may impose on a country an imbalance between its
demand for and supply of money. This imbalance then must be adjusted away
by the Wicksell Process, since money still lacks a market of its own on which
a price of its own adjusts to equilibrate supply and demand. (The foreign
exchange market and rate do not serve this function; and anyway, the exchange
rate is fixed.) When the process of imported inflation imposes additional money
on a country, prices and nominal income have to rise until the expanded money
supply is demanded after all, and conversely with imported deflation (see
Chapter 9). Thus, even under fixed rates, money is supplied and demanded in
a distinctive way and still can be thrust onto or withdrawn from its holders in
the aggregate in a way that does not also characterize nearmoneys.
With a freely floating exchange rate, no pegging is at work to alter the domestic
money supply. The price of foreign exchange in home money is just one of the
many prices that adjust to bring the nominal demand for cash balances into line
with the nominal supply and the real supply into line with the real demand.
The exception to the fundamental proposition that we have been noting
applies not only to a country with a fixed exchange rate but especially to a
locality within a country. (Here country really means the area routinely using
a common currency.) In using the same currency, the different parts of a country
are linked together even more tightly than if they were using different currencies
at fixed exchange rates. The money holdings of residents of Chicago as well as
the aggregate deposits of Chicago banks, like the deposits of a single bank, are
not determined by some monetary authority. For the money-multiplier analysis
of the money and banking textbooks to be useful, the determinants of the
multiplier must be reasonably stable and the monetary base potentially controllable, and the latter is not true of Chicago alone (compare Masera, 1973,
pp. 1456, 1556). If Chicago banks alone should decide to expand deposit
money, drainage away of reserve funds would frustrate them. If Chicago
residents should act to build up their bank deposits, reserves would flow into
their banks through a local balance-of-payments surplus, supporting the desired
expansion of deposit money.
The fundamental proposition about how the supply of money creates its own
demand in nominal terms refers, then, not to each part of a single monetary area