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Missing 2.3 trillion dollars

Asked by rancagringo | Aug 19, 2007 | University Level > Economics > Advice
rancagringo
rancagringo asks:

What would be the expected economic consequences of the "disappearance" of 2.3 TRILLION dollars, as alleged by sec. Rumsfeld, if
A. the report was false, but widely believed
B. the report is true, money appears in circulation
C. the money was stolen and lies dormant, unused
D. the money is destroyed, or otherwise removed from circulation.

etutor answers:

This is a very bizarre question, and it is far from obvious what it is driving at. This is because there is no indication of where the money has 'disappeared' from. Treasury accounts? Private banking accounts? Private cash holdings through theft? Moreover, Rumsfeld ceased to be Defense Secretary in November 2006. Looking at the four questions, it appears that the 'money' in question is in the form of bank notes - in other words, cash. It is also a vast amount in total, and so any impact is presumably designed to be significant. Given the ambiguities outlined above, my suggestions are:

A. This might be an exercise in adaptive or rational expectations theory. If the report is widely believed, then in general people will expect there to be a rise in the rate of inflation as more will be spent, contributing to aggregate demand. On this basis, people are likely to bring forward their purchases with a view to avoiding the higher prices. Many might reduce their savings do to so. The effect would tend to be to bring about the very price inflation that they feared. The extent to which this is true partly depends upon aggregate supply - the more inelastic the curve, the greater the addition to inflation.

B. In principle, much the same answer, though the process will be quicker, as the vast amount of money has (somehow) appeared in circulation. There will be less need to run down savings or to resort to bank loans to finance additional expenditure. The inflationary impact also depends in part on the relationship between the money supply and the price level. According to the Quantity Theory, if the income velocity of circulation and the volume of transactions are broadly constant, then there is a direct and proportionate relationship between the increase in the money supply and the price level. There is also a likelihood of a wage-price spiral developing. Moreover, people are more likely to invest in speculative assets (including housing) where prices are expected to rise at a rate higher than general inflation.

C. It depends from whom it was stolen. If the previous owner(s) had intended to spend it and the new 'owners' do not, then it constitutes a reduction in the volume of active money in circulation. Assuming a strong relationship between the quantity of money and the level of aggregate demand (see above - Quantity Theory) then the outcome would be a significant reduction in output and employment. There would also be a downward multiplier effect, exacerbating this trend. There should be some moderation of price increases as a result. Eventually, however, if the stolen money re-enters circulation and is then spent, this process would go into reverse.

D. The answer seems to be the same as in C. It is possible, however, that the velocity of circulation of that money remaining in circulation now increases. According to the Quantity Theory, if the increase in the velocity of circulation matches the fall in the stock of money, then national income would remain unchanged. There is also the possibility that news of the theft makes people less confident about the future, in which case they may choose to spend less and save more, as a precautionary measure. In this case, there would be a reduction in aggregate demand, output, employment and price/wage inflation. Insurance companies are likely to prosper, if people fear similar thefts - premiums would tend to rise.

I hope this helps.

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Damon
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