Real Balance Effect

Updated on January 31, 2024
Article byNanditha Saravanakumar
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Real Balance Effect?

The real balance effect theory postulated by economist Don Patinkin states that an increase in the amount of money in the economy first affects the demand and relative price levels and then the absolute prices. Through the effect, Patinkin aimed to integrate the monetary and real sectors.

Real Balance Effect

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Patinkin put forward the theory to prove the failure of the classical quantity theory of money. The real balance implies the money in the hands of the public divided by economical price levels. In simple words, it can be referred to as purchasing power.

Key Takeaways

  • The real balance effect refers to a rise in money stock with the public leading to an increase in demand and price level of goods and services in an economy.
  • Thus, using this theory, Don Patinkin, in 1956, through his work ‘Money, Interest, and Prices’, sought to merge the real sector (commodity and labor markets) and the monetary sector (money market).
  • Real balance refers to the purchasing power of the people, and the theory establishes the relationship between the real balance, demand and supply, price levels, and employment.

Patinkin’s Real Balance Effect Explained

Real balance effect macroeconomics can be understood with the origin of the term and the concept. Economist Arthur Cecil Pigou introduced the term ‘real balance.’ In an economy, it refers to the purchasing power of the public or the money with them. Mathematically, real balance can be referred to as the stock of money with the public divided by price level, which is the purchasing power.

Patinkin initially introduced the theory as a criticism of the classical quantity theory. It states that an economy’s money supply is directly proportional to the absolute price level. Hence, if the money supply doubled or tripled, the same would be the case with economic prices.

But there are three main issues with the theory:

  1. First, there is no information about the relative prices.
  2. The theory dichotomizes the monetary and real sectors. Hence, an increase in the money supply would not affect the demand and supply of goods.
  3. The theory assumes money doesn’t affect an economy’s productivity.

Hence, Patinkin disproved the quantity theory using the real balance effect. It states that as the money supply increases, the demand and price levels for goods and services and the absolute economical prices increase. Patinkin believed that price level influences the real balance, thus affecting the demand. Therefore, the effect has facilitated the integration of monetary, real, and labor markets.

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Example

Here’s a simple example of how the macroeconomics real balance effect works. Suppose the real balance in an economy at a point in time is $1 billion. Due to efficient economic policies and reformations, it increased to $2 billion. So obviously, people’s disposable income will increase, and so does related parameters like expenditure, demand, and prices. So the inflation rose to 6%, and the employment rate increased to 70%.

However, due to inflation and accelerated spending, the purchasing power dropped to $900 million. So people spent less, thus decreasing the demand. As a result, the inflation rate fell to 1.5%, and the employment rate also slipped to 55%.

Real Balance Effect On Aggregate Demand

Let’s understand the effect of Patinkin’s theory on demand by evaluating the integration of money and labor markets with the demand and supply of goods and services. Firstly, an increase in real balance contributes to purchasing power. This leads to an increase in consumer spending; thus, demand for goods and services will go up. To satisfy increased demands, supply will have to rise too.

Hence, employment will increase, and demand for labor will drive up wages. This, in turn, increases the money stock with people as more and more people are employed. However, another cycle is set, where public money increases trigger a demand-induced price hike. Over time, the high prices will reduce the purchasing power of the people. So demand falls, along with general price levels and, consequently, employment rates.

Graph

The real balance effect theory can be represented in the IS-LM curve. IS curve denotes the commodity market, whereas the LM curve denotes the money market. The graph is plotted with income, output (Y) along the X-axis, and interest rate (R) along the Y-axis.

IS-LM Curve Representing Real Balance Effect

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Initially, the IS and LM curves intersect, and there is an equilibrium output level (E). If the full employment level of output occurs at Y = YF, then the pressure of unemployment ( YF – Y) would reduce wages and the general price. But this would contribute to an increase in natural balance, as there is more money with people.

Hence, the LM curve shifts to the right to LM1. This intersects with IS curve but at a lower rate of interest (R1) than the equilibrium interest rate (R). Lower interest rates will encourage investments, and income will increase. However, there is still unemployment (YF – Y1). Therefore, the wages will still fall along with prices. A fall in prices increases demand. Hence the IS curve shifts to IS1. It intersects with LM2 at E2, where the full employment level of output is reached.

Frequently Asked Questions (FAQs)

1. Who propounded the real balance effect?

The term ‘real balance’ was introduced by Arthur Cecil Pigou. But the theory was established by another economist Don Patinkin, who adopted Pigou’s term to criticize and disprove the classical quantity theory of money.

2. What is the real balance effect in economics?

Patinkin’s theory claims that as real balance (stock of money with the public) increases, their purchasing power rises too. This stimulates a rise in consumer expenditure and subsequently drives the demand in the commodity market upward. As demand increases, so does price level (relative and absolute) and employment. Extended inflationary pressures reduce the real balance over time, pushing demand and general price downwards.

3. How the real balance effect affects aggregate demand?

The real balance effect affects demand by integrating money and commodity markets. Money increases consumer spending, which contributes to an increase in demand. Similarly, a decrease in real balance will arrest people’s spending capacity, thus reducing aggregate demand.

This article has been a guide to what is Real Balance Effect by Don Patinkin. Here, we explain the topic in detail, its example, graph, and its effect on aggregate demand. You may also find some useful articles here –

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  1. kadzima bByron t says

    Really helps me

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