Applied Econometrics

While Austrian economists probably generally believe that econometrics has a similar relationship to economics as astrology has to astronomy, it seems only fair to give econometricians a chance to prove otherwise. Accordingly, the problem described below has both an arithmetic part and a policy part.

Imagine that Walmart has a secret Chinese subsidiary on the mainland that has developed the ability to produce perfect, undetectable, counterfeit Federal Reserve Notes ( $1, $5, $10, $20, $50, and $100 ) without significant cost.

During the entire year of 2005, and not thereafter, Walmart uses the counterfeits to make change in all of its US stores, while depositing all of the genuine FRNs that it receives in its bank account(s). What will be the effect on the general purchasing power of the dollar over time? Use any data available and any assumptions that seem appropriate.

The above is the arithmetic part of the problem, although there will be no single right answer.

The policy part of the problem is as follows:

The counterfeits turn out in practice to be too perfect in that they simply do not wear out or collect dirt or grime. In 2010, the Secret Service realizes that a subset of the circulating FRNs are not being turned in for replacement even though they are now 5 years old, far beyond normal FRN lifetimes.

What is the best economic policy for the Treasury to pursue with respect to the counterfeits, and what will the economic effects of that policy be?

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So, can it be proven in

So, can it be proven in court that Walmart was the perpetrator of the counterfeiting? If so, obviously they have to pay back what they've effectively stolen from the treasury. As for how Walmart could repay the damage done to all of us through inflation, I have no idea.

scrap FRN's entirely and

scrap FRN's entirely and learn a lesson from Wal-mart by privatizing the currency system. This act could also severly undermine the store by depreciating all its stored FRN's.

Stephan

Don, I'll take a stab at

Don,

I'll take a stab at this.

During the entire year of 2005, and not thereafter, Walmart uses the counterfeits to make change in all of its US stores, while depositing all of the genuine FRNs that it receives in its bank account(s). What will be the effect on the general purchasing power of the dollar over time? Use any data available and any assumptions that seem appropriate.

I'm assuming there is a one-for-one exchange,i.e., one real FRN is replaced with one equivalent denomination counterfeit FRN.

Walmart increases the overall money supply by the amount of extra cash deposited in its bank accounts. I don't know enough about the various money supply measures to know what impact this will have on econometric statistics.

The change in purchasing power will come from a decrease in the intensity of the desire of Walmart's management to hold cash in leiu of spending it and the extra cash will percolate through the economy in different ways - from capital expenditures, wages paid to employees, dividends disbursed, etc. I have no idea how to quantify this. Walmart will benefit at the expense of the rest of us as they get to spend the new money first.

After realization of Walmart's counterfeiting, the Treasury should make Walmart pay back the amount of counterfeit money it originally made (and a hefty fine for future deterrence.) The transient 'kinetic' effects can never be corrected for. It's like trying to put toothpaste back into the tube.

Jonathan, Walmart increases

Jonathan,

Walmart increases the overall money supply by the amount of extra cash deposited in its bank accounts. I don’t know enough about the various money supply measures to know what impact this will have on econometric statistics.

Nor do I, but the first reduction in the purchasing power of money will likely result from the ability of the banks to expand credit based on their possibly temporarily increased deposits.

The change in purchasing power will come from a decrease in the intensity of the desire of Walmart’s management to hold cash in leiu of spending it and the extra cash will percolate through the economy in different ways - from capital expenditures, wages paid to employees, dividends disbursed, etc. I have no idea how to quantify this. Walmart will benefit at the expense of the rest of us as they get to spend the new money first.

I don't quite think so. If we assume that Walmart already has cash in the bank even before the additions to the account balances due to the counterfeit replacements, then it is relatively unlikely that it will change its investment and employment patterns. It will be largely when the increased dividends paid reach individuals and reduce the subjective marginal utility of their cash balances that their consumption patterns may change.

Individuals may now buy $3 candy bars at the margin that would have been deemed too expensive before when cash balances were smaller. This would tend to incrementally increase the price of candy bars.

Individuals may make choice changes, for example changing from buying $4 apples to buying $5 oranges as the marginal utility of the cash price has been diminished. This would tend to increase the price of oranges and reduce the price of apples.

After realization of Walmart’s counterfeiting, the Treasury should make Walmart pay back the amount of counterfeit money it originally made (and a hefty fine for future deterrence.) The transient ‘kinetic’ effects can never be corrected for. It’s like trying to put toothpaste back into the tube.

The pricing effects are both transient and permanent.

The first choice to be made by the Treasury is whether to confiscate the counterfeits and whether to replace them. If it chooses to confiscate them without replacement, it is effectively contracting the money supply, with the direct effects punishing people that did not benefit by the counterfeits in the first place. There is no real advantage in trying to offset the increase in prices that has already spread throughout the economy. The economy largely runs and adapts to relative prices, not absolute ones. Any supply of money is as good as any other. It is arbitrary non-neutral changes in the money supply that cause the destruction of existing capital as the economy re-adjusts to relative price changes, whether the overall absolute price change is an increase or a decrease.

Rather than fine Walmart and risk making the counterfeiting public, reducing public confidence in money, it likely should make a secret deal with Walmart for its superior money production process and start making and replacing its own worn out money with new money made with the long-lived Walmart process.

Regards, Don

Jonathan, To follow up

Jonathan,

To follow up :

Individuals may make choice changes, for example changing from buying $4 apples to buying $5 oranges as the marginal utility of the cash price has been diminished. This would tend to increase the price of oranges and reduce the price of apples.

If the price of oranges goes up and the price of apples goes down, then the price of orange-picking machines and apple-picking machines will tend to follow. These prices of higher order production goods will not change to a first order because of variations in the cash balances (individual money supply) of their potential buyers, but because of variations in the marginal value product of the production factors. These are imputed prices driven by the subjective valuations of consumers of first order consumer goods and dependent on the diminishing marginal utility of larger cash balances of consumers due to increased money supply.

Regards, Don

Jonathan, Further follow-up

Jonathan,

Further follow-up :

Assume a homeowner and a teenager with a lawnmower.

If an increase in the money supply happens to end up in the cash balance of the homeowner, his resulting diminished subjective marginal utility of money tends to increase the amount of money that he will be willing to pay to have his lawn mowed.

Alternately, if an increase in the money supply happens to end up in the cash balance of the teenager, his resulting diminished subjective marginal utility of money tends to increase the amount of money he will require to mow a lawn.

In both cases, the price of lawnmowing tends to rise.

On the other hand, if an increase in the money supply happens to end up in the cash balance of a contract employer of lawn-mowing teenagers, he is not driven by subjective valuation and diminishing subjective marginal utility, but rather by objective profit. An increase in his cash balance is presumably a sunk profit, and forward pricing will maximize forward potential profits, and lawn mowing prices will not be driven up by the increase in the money supply that he sees. It is only when he adds the increase in money supply to his individual cash balance as a consumer that the prices of the goods that he CONSUMES goes up.

Regards, Don

So I presume that if the

So I presume that if the teenager were mowing lawns for profit and not simply to gain cash, then he'd react in the same way the contract manager?

Brian, So I presume that if

Brian,

So I presume that if the teenager were mowing lawns for profit and not simply to gain cash, then he’d react in the same way the contract manager?

I don't see a useful distinction between profit and cash.

If the teenager is working for current discretionary spending money which he spends in a price sensitive manner, then any of the increase in money supply which ends up in his pocket will tend to increase prices on the products that he might purchase for consumption.

If he is saving for college or something else, and the increase in money supply ends up in his saved balance where it has no effect on his current discretionary spending, then there is no tendency to increase prices.

If he saves it in a bank, then it may tend to produce credit expansion by the bank. This will not be the case if he buries the savings in a jar in the backyard.

Regards, Don

I only brought it up

I only brought it up because:

On the other hand, if an increase in the money supply happens to end up in the cash balance of a contract employer of lawn-mowing teenagers, he is not driven by subjective valuation and diminishing subjective marginal utility, but rather by objective profit. An increase in his cash balance is presumably a sunk profit, and forward pricing will maximize forward potential profits, and lawn mowing prices will not be driven up by the increase in the money supply that he sees. It is only when he adds the increase in money supply to his individual cash balance as a consumer that the prices of the goods that he CONSUMES goes up.

I am grokking the whole "its the consumption side that affects & reorders prices and pricing" insight, but it would seem that the reason the contract employer would not raise the price of lawnmower services with a cash infusion would not be because he's motivated by objective profit but for the reason you gave in response. The degree to which the extra cash affects consumer prices is directly related to the "marginal propensity to save/consume" of the actor in question.

Brian, I am grokking the

Brian,

I am grokking the whole “its the consumption side that affects & reorders prices and pricing” insight, but it would seem that the reason the contract employer would not raise the price of lawnmower services with a cash infusion would not be because he’s motivated by objective profit but for the reason you gave in response. The degree to which the extra cash affects consumer prices is directly related to the “marginal propensity to save/consume” of the actor in question.

I can't see why there would there would be any tendency for a cash infusion to raise the price of lawnmower services, whether we are talking about the consumer good of lawnmowing or the production good of the teenager's labor.

The contract employer sits in the middle of two competitive markets, as a buyer of labor and as a supplier of lawnmowing services. To the degree that he can influence prices on both sides, he will attempt to maximize his profits. If an investment in increasing the scale of his operations will earn him more money, he will make the investment, but the opportunity for such an investment will almost certainly be limited.

If the contract employer has made all his investments that earn a positive return and is operating in a dynamic equilibrium profit-maximizing mode, then if he is the individual/business that receives an increment in the money supply, why should this have any effect on his operations, or any effect on the pricing of either his supplied services or his hired production factor?

It seems to me that the increment in the money supply will simply be disgorged as part of the dividend flow to the owner(s). There it MAY affect CONSUMER prices for consumer goods that the dividend receivers choose to buy or not buy, but this is independent of the prices of lawnmowing services.

Do you have something else in mind?

Separately, the “marginal propensity to save/consume” doesn't seem to me to be an Austrian-accepted concept.

The last dollar spent in current consumption is determined by the subjective marginal utility of the least
valued consumption good purchased and the present value of the choice that a saved dollar provides from an array of future consumption goods, discounted by an individual's rate of time preference for present goods over future goods.

Regards, Don