So, let’s say hypothetically we have an island economy with nothing but barter. And then suddenly millions of dollar bills fall from the sky and get distributed randomly across the population. Everyone immediately accepts dollars as the medium of exchange and the economy becomes a monetary economy. What happens next? How does the price of money come to exist?
My real question behind this story is to ask why the nominal stock of money in an economy doesn’t matter. It makes no difference whether there are one million dollars or one trillion, the real economy is not affected.
The first part of your post merits a different response than your second. In terms of money neutrality, I think most economists agree that money is not neutral in the short-run. However, there are many economists who do believe that money is neutral in the long-run, and I think that’s best explained as an adherence to a general equilibrium theory, where the economy is headed towards equilibrium. For example, in The Stiglitz Report Stiglitz writes that the market should have smoothed any imbalanced caused by newly created credit over the long-run. I think Austrians have a unique perspective, because they recognize that this “equilibrium” is always shifting with changing underlying data, and new money creation changes this underlying data, so the “long-run equilibrium” (which is unattainable, but we’re using it as a sort of highway marker) is different from that which existed prior to the introduction of new money.
In regards to your first paragraph, I would suggest looking up Mises’s regression theorem. If money fell from the sky into a society which had up to then used barter then the chances are that that ‘money’ would not be money at all, since money isn’t money out of its physical characteristics, rather as its acceptance as a general medium of exchange.
As far as I can tell your post has nothing to do with the actual neutrality, or lack thereof, of money. So the quantity of money doesn’t matter per se because let’s forget a barter economy for the moment, let’s take the U.S economy today. Let’s suddenly take the money supply and multiply it by two, if all you have in the bank is 100 dollars, you now have 200 dollars, all taxes and interest rates stay the same, all set numerical duties, fees, and prices double. Everything is exactly the same. There is absolutely no change in the actual value of goods or number of goods available. If we double the number of dollars the real number of goods increases, if we double the number of goods however, everyone is suddenly far, far richer than they previously were.
If you and I live in a simple economy by ourselves and we use a medium of exchange then increasing the number of the medium of exchange does nadda in terms of the total wealth of our society in terms of goods and services, however if the amount of goods increases (assuming of course we want the goods produced) means that we are going to be better of materially. Money is just a medium of exchange, a number, it gains value out of all goods and services in society, all goods and services in society are not given value by money. People want goods and services, and it just so happens money is a mean to this end.
As for your example according to the regression theorem it is impossible. A currency which is dropped onto the population cannot be evaluated. If we eradicated all prices out of the minds of every member of society then people would have no idea what the dollar value of anything was worth, and what we now use as money would only be valued out of how attractive it is. Money, when it is first considered a money, has gained its value because of how much people want to consume or produce it. Money, from then on out can receive its worth from two places, if you’re talking about gold money it received its value from what, say, a jeweler could use for it (especially in the case of gold this became an increasingly negligible amount) and from what it could buy on the market. This is why nations can go off of the gold standard, because of the fact that the money they own gains value from what it can buy, even if the money might be technically be worth almost nothing and, if prices were wiped out, would probably not even be a medium of exchange any more.
But what if the island is held hostage by terrorists who threaten to slaughter everyone if the people in the economy do not figure out how to use it as a medium of exchange?
If dollar bills fell from the sky and everyone on the island decided to use them for whatever reason as money then prices would form as they do now - through supply and demand. I’m not sure what you’re trying to get at.
Not to be condescending, joemac, but I think you could clear up 90% of your questions by reading a little more. I recommend reading this. Regarding the nature of fiat money, listen to this.
“But what if the island is held hostage by terrorists who threaten to slaughter everyone if the people in the economy do not figure out how to use it as a medium of exchange?” - joemac
Then you get the US government and the Federal Reserve System.
“If dollar bills fell from the sky and everyone on the island decided to use them for whatever reason as money then prices would form as they do now - through supply and demand. I’m not sure what you’re trying to get at.”
Not if the money had no inherent worth, no prices would be able to form if paper money just fell from the sky, well any wealth of any value, no more than what the sheets of paper and the ink add up to.
If Terrorists threatened the society people would probably just randomly ascribe a value to the money, no stable type of currency could possibly emerge unless the money already had value. The terrorists, for instance, might be able to make silver into a money, but they could not make a barter society into a fiat economy.