Real Balance
Real balance is the value of money holdings expressed in terms of the goods and services that they can purchase. The real balance effect is the effect of a change in real balances on consumption and on aggregate demand.
Concept
Real balances are the nominal money holdings of households and firms divided by the price level. They represent the purchasing power of the money that is held.
The real balance effect operates when a change in the price level alters the real value of money holdings, which affects the spending decisions of households. A fall in the price level raises the real value of money holdings, which raises consumption, and vice versa.
The Real Balance Effect
The real balance effect, also known as the wealth effect, was emphasised by economists including Arthur Pigou, who argued that it provides a mechanism for the economy to return to full employment.
The argument is that a fall in the price level raises the real value of money holdings, which raises consumption, which raises demand, which raises output. The effect provides a channel through which the price level can affect output, even when the interest rate is at its lower bound.
The strength of the effect depends on the size of the money holdings and on the responsiveness of consumption to wealth. The empirical evidence suggests that the effect is small, which limits its practical importance.
Criticisms
The real balance effect has been criticised on several grounds. The effect is small, and it may be offset by other effects of a fall in the price level, including the increase in the real burden of debt.
The debt deflation effect, identified by Irving Fisher, holds that a fall in the price level raises the real burden of debt, which reduces the net wealth of households and firms, which reduces spending. The effect works in the opposite direction to the real balance effect, and it may dominate.
The criticisms mean that the real balance effect is not a reliable mechanism for the restoration of full employment, and that the economy may remain below full employment for a prolonged period.
Uses
The concept of real balances is used in the analysis of the demand for money, where the demand is expressed as a function of real income and of the interest rate. It is used in the analysis of the effects of monetary and fiscal policy.
The concept is also used in the analysis of inflation, where the erosion of real balances by inflation is a cost of inflation. The inflation tax is the reduction in the real value of money holdings that results from inflation, and it is a transfer from the holders of money to the issuer.
The Demand for Money
The demand for the money balances is the analysis of the amount of the money that the households and the firms choose to hold. The demand depends on the income and on the interest rate, and it is often expressed as the demand for the real balances.
The demand for the real balances rises with the income, since the transactions require the money, and falls with the interest rate, since the money bears less return than the other assets. The relationship is central to the analysis of the monetary policy.
The stability of the demand for the money is a central issue. The evidence on the stability is mixed, and the instability complicates the use of the monetary aggregates as the targets of the policy.
The Seigniorage and the Inflation Tax
The inflation reduces the real value of the money holdings, and the reduction is a form of the taxation of the holders. The revenue from the creation of the money is the seigniorage, and the erosion of the value is the inflation tax.
The inflation tax is a transfer from the holders of the money to the issuer, and it is a source of the revenue for the government. The tax is often regressive, since the poor hold a larger share of their wealth in the form of the money.
The analysis of the seigniorage informs the design of the monetary policy and the assessment of the fiscal position. The reliance on the seigniorage can lead to the high inflation and to the hyperinflation.
The Wealth Effect
The real balance effect is a form of the wealth effect, in which the change in the real value of the money holdings affects the consumption. The effect is one of the channels through which the price level affects the demand.
The strength of the effect depends on the size of the money holdings and on the responsiveness of the consumption to the wealth. The effect is generally small, which limits its practical importance.
The effect also interacts with the debt deflation, which works in the opposite direction. The net effect depends on the balance between the two, and the analysis of the effect must consider both.
Summary
Real balance is the value of the money holdings in terms of the goods that they can purchase, and it is central to the analysis of the demand for the money and of the effects of the inflation. The real balance effect and the inflation tax are the applications of the concept.