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.
