Chronicles of a Deflation Unforetold
Suppose the nominal money supply could be cut literally overnight by, say, 20%. What would
happen to prices, wages, output? The answer can be found in 1720s France, where just such an
experiment was carried out, repeatedly. Prices adjusted instantaneously and fully on one market
only, that for foreign exchange. Prices on other markets (such as commodities) as well as prices
of manufactured goods and industrial wages fell slowly, over many months, and not by the full
amount of the nominal reduction. Coincidentally or not, the industrial sector (as represented
by manufacturing of woolen cloths) experienced a contraction of 30%. When the government
changed course and increased the nominal money supply overnight by 20%, prices responded
much more, and the woolen industry rebounded.