A Tactic for Explaining the Reality of Imperceptible, but Real, Effects

by Don Boudreaux on April 11, 2006

in Education, Trade

Tonight in my Principles of Microeconomics class ("ECON 103" at George Mason University) I explained to my students the "real-cash-balance effect."  This is the straight-forward idea that any change in the size of the nominal stock of money in circulation doesn’t change the real purchasing power of the total stock of money.

If, for example, the economy today has available for purchase four apples, three lightbulbs, two bottles of wine, and one automobile, no change in the amount of currency in circulation will change this fact.  If the amount of currency in circulation is doubled, the purchasing power of each unit of currency will be cut in half; if the amount of currency in circulation is cut in half, the purchasing power of each unit of currency remaining in circulation will double.  But in both cases the total amount of goods and services available to be purchased will be unchanged.

I explained to my class that if foreigners who earn dollars by selling goods and services to Americans lost their dollars, or chose to shred and burn their dollars, the purchasing power in these lost or destroyed dollars would nevertheless return to the U.S. economy in the form of higher purchasing power of the dollars remaining in circulation.  It’s the real-cash-balance effect.

But one difficulty in explaining this effect to students is their correct intuition that any amount of dollars that foreigners might hoard or destroy is a teensy-weensy fraction of the total stock of dollars — such a small fraction that the increase in purchasing power enjoyed by dollars remaining in circulation (as a result of foreigners steadfastly and forever refusing to spend their dollars) is so small as to be unnoticeable.

And that which is unnoticeable seems unreal — or, at least, questionable.

So here’s the analogy I use: Suppose you’re standing on the edge of an Olympic-sized swimming pool.  The water in the pool is perfectly still.  You pull a dime from your pocket and toss it into the pool, and you watch it sink to the pool’s bottom.

Does the addition of the dime to the pool raise the pool’s water level?  Of course it does.  Is this effect noticeable?  No, it’s not.  But the fact that the higher water level (resulting from a lone dime being chucked into the pool) is unnoticeable does not mean that the effect isn’t real.

And so it is with the real-cash-balance effect.  Any amount of dollars that foreigners keep ‘permanently’ out of circulation — because foreigners lose some dollars, because some dollars start to circulate as currency abroad (as in Panama), or for whatever other reason — will be such a small portion of the supply of dollars that the effect that this reduction in nominal cash balances will have on the purchasing power of dollars remaining in circulation will be imperceptibly small — imperceptibly small, but nevertheless undeniably real — just as real as is the increase in the level of the pool caused by the lone dime.

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{ 13 comments }

Kimbell Duncan April 12, 2006 at 4:18 am

So what?

Don Lloyd April 12, 2006 at 8:56 am

Don,

"…But one difficulty in explaining this effect to students is their correct intuition that any amount of dollars that foreigners might hoard or destroy is a teensy-weensy fraction of the total stock of dollars …"

Does this 'teensy-weensy' fraction include the dollar reserves held by the Chinese central bank?

Regards, Don

bbartlog April 12, 2006 at 11:49 am

Hmm… given that price information is more or less quantized, it sounds like you really need a quantum theory of economics to deal with small effects like this. I imagine it's been done already (though the results would I'm sure not be appropriate for ECON 103…)

Matthew Aguilar April 12, 2006 at 1:28 pm

Fallacy is that foreigners don't hoard there USD, they lend them back to us. Foreigners are buying up Fannie Mae's, the National Debt, and piling up USD in CD's and other Bank Deposits in unbelievable quantities [this accounts for the "net capital inflow" that counterbalances the U.S. Trade Deficit]. The result is that U.S. Financial Services are doing a booming business even though the American "savings Rate" (inaccurate because investments are counted as "spending") is negative. Remember the saying "I owe you 10,000, you got me; I owe you 10,000,000, I got you." Foreigners are naive enough to buy up the National Debt, and wise enough to save their capital in USA. This strengthens the U.S. Economy [at the expense of Socialist countries] and lowers interest rates. It also reduces the control of the Fed over the U.S. money supply and is the cause of the Flat Yield curve. The reason the USD does not Depreciate is that Foreigners have their life savings here and have the most to lose if it does.

Matthew Aguilar April 12, 2006 at 1:44 pm

More to the point, the minute effect of USD hoarding abroad is overwhelmed by the Fed increasing the Money supply here, which is partially offset by ecomonic growth (more goods and services produced in U.S. Economy) The rest of the increase in the Money Supply causes inflation.

Mickey Klein April 12, 2006 at 2:31 pm

The US M2 money supply is only 6.7 trillion. The Chinese have nearly one trillion of this tucked under the bed. Althought I dont think this is necesarily dangerous I would imagine it is doing something more to the dollar than a dime in a swimming pool.

http://www.forecasts.org/m2.htm

cb April 12, 2006 at 2:56 pm

I am puzzled about the dime in the swimming pool analogy too.
what numbers would you put on the total foreign dollar and debt holdings?
China is only one small piece of the dollar holding. i am guessing the foreign government, commercial, private holdings of us dollars are a fairly sizable percentage of the swimming pool (25%?? ).

Don Boudreaux April 12, 2006 at 4:00 pm

I apologize for being unclear in this post. (That's what happens when I — a morning person — write a post just before midnight.)

My goal was not to make any empirical statement about the size of foreign dollar holdings. My goal, instead, was to share with other teachers an analogy that I find useful to help students see that consequences can be real even though imperceptible.

Preston April 12, 2006 at 4:48 pm

What happens if the amount of money in circulation (in your example) is doubled by giving it to the owner of the 4 apples and the Fed and the apple owner do not share that info with anyone else? I would suppose that the apple owner would buy everything else that he (she) could and then get the info out about the doubling of currency then sell everything for a tidy profit.

gary April 12, 2006 at 8:17 pm

Dear Don,
If I give 100 dollars to the Chinese and they burn them, what happens to the US capital account. I can see the US current account deficit but, in this case, wheres the US capital account surplus (if any?).

Mickey Klein April 13, 2006 at 12:15 am

If you recieved goods or services for the 100 dollars then you have recieved full value in utility. If you just gave then 100 dollars out of the good of your heart then you lost money.

If they burned the money after the exchange then you have 100 dollars in utility and they have nothing.

The capital account surplus would come into effect if they invested the dollars in US stock.

Noah Yetter April 13, 2006 at 1:59 pm

A very useful analogy Don, I will remember it.

Kevin April 13, 2006 at 2:43 pm

Next you could do a class on the "My-cash-balance effect", wherein I find that that as MY currency disappears towards the end of the month, I really do suffer from diminishing buying power. Hello beans and Ramen.

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