Real Balance Effect
The real balance effect, also called the Pigou effect or the wealth effect of money, is the change in consumption that results from a change in the real value of money balances held by households. When prices fall, the purchasing power of a given stock of money rises, making holders feel wealthier, which leads them to increase consumption. This mechanism was proposed as a means by which a fall in prices could raise demand and restore full employment, providing a self-correcting mechanism for the economy.
The mechanism
The real balance effect operates through the wealth of households. Money is an asset, and a fall in the price level raises the real value of any given nominal money holding. Because households consume partly on the basis of their wealth, an increase in real balances raises consumption, which raises aggregate demand, output, and employment. Conversely, a rise in the price level reduces real balances, reducing consumption and demand.
The effect is related to, but distinct from, the wealth effect of asset prices. The real balance effect concerns the purchasing power of money, while the wealth effect concerns the value of financial and real assets such as equities and housing. Both operate through the wealth of households, but they arise from different sources, and their magnitudes differ, with the effect of money balances generally smaller than that of asset prices.
Significance for classical and Keynesian theory
The real balance effect was important in the debate between classical and Keynesian economics. In the classical view, the economy tends toward full employment, and a fall in prices should raise demand and restore equilibrium. The real balance effect provides a mechanism for this adjustment, showing how a lower price level could raise consumption and thereby raise demand. In this way, it supported the classical argument that a market economy is self-correcting.
Keynesians questioned the practical importance of the effect. They argued that the effect is small, because money holdings are a small part of household wealth and because the response of consumption to wealth is modest. They also noted that falling prices may be accompanied by expectations of further falls, which delay purchases, and by debt deflation, in which the real burden of debt rises, redistributing income from debtors, who have a high propensity to consume, to creditors, who have a low one. These effects could offset or reverse the real balance effect.
Debt deflation
Debt deflation, described by Irving Fisher, is a mechanism through which falling prices can depress rather than stimulate the economy. When prices fall, the real value of outstanding debt rises, transferring income from debtors to creditors. If debtors have a higher propensity to spend than creditors, the transfer reduces aggregate demand. Falling prices may also trigger defaults and financial distress, which further reduce spending and lending.
Debt deflation can offset the real balance effect, particularly when the level of debt is high and when the fall in prices is large. The combination of the two mechanisms means that the net effect of falling prices on demand is ambiguous and depends on the levels of debt and of money balances, and on the distribution of both. The experience of the Great Depression, in which falling prices were accompanied by falling output, illustrated the potential for deflation to be destabilising rather than self-correcting.
Modern relevance
The real balance effect remains relevant to the analysis of monetary policy and of deflation. In economies where nominal interest rates are near their lower bound, the ability of monetary policy to stimulate demand is limited, and the real balance effect is one of the channels through which an expansion of the money supply might raise demand, by raising the real value of money balances. The effectiveness of this channel is, however, uncertain and generally modest.
The effect is also relevant to the analysis of the wealth effects of asset purchases. When a central bank buys assets, it changes the composition of private portfolios and may affect wealth and spending. The real balance effect is one component of these broader wealth effects, and its importance relative to other channels remains an area of research, particularly in the context of unconventional monetary policy and of the withdrawal of such measures.
The Pigou effect and the liquidity trap
The real balance effect is closely related to the debate about the liquidity trap. In Keynes's analysis, at very low interest rates, the demand for money may become perfectly elastic, so that additional money is absorbed without lowering rates, and monetary policy loses its power. The real balance effect, emphasised by Pigou, provided a counterargument, suggesting that even in a liquidity trap, a fall in prices would raise real balances and thereby raise demand, so that the economy would not settle at a depressed equilibrium.
The counterargument depends on the size of the effect and on the absence of offsetting forces. If the effect is small, it may not be sufficient to restore full employment within a reasonable time. If debt deflation is significant, it may offset the effect. The debate therefore turns on empirical magnitudes, and the experience of the Great Depression and of more recent episodes of deflation suggests that the real balance effect is generally too weak to be a reliable mechanism for restoring full employment.
Fiscal and monetary implications
The real balance effect has implications for the design of policy. It suggests that policies that raise real balances, including expansionary monetary policy, can support demand through the wealth channel, although the effect is weak. It also implies that policies that raise the price level, such as those that create inflation, reduce real balances and depress demand, which is part of the reason why high inflation is costly.
The effect also informs the analysis of fiscal policy. If the real balance effect is operative, then a fiscal expansion financed by money creation may raise prices and reduce real balances, offsetting part of the stimulus. The interaction between monetary financing, prices, and real balances is central to the analysis of the limits of monetary financing, and it explains why persistent monetisation leads to inflation rather than to sustained increases in output.
Measurement and empirical evidence
The measurement of the real balance effect requires estimates of the response of consumption to changes in real money balances, holding other influences constant. The effect is difficult to isolate, because changes in prices and in money holdings are correlated with other changes in the economy, and because the response is small and slow. Empirical estimates suggest that the effect is positive but modest, and that it is smaller than the effect of other components of wealth.
The evidence has implications for the analysis of deflation. If the real balance effect is weak, then deflation may be destabilising rather than self-correcting, because the debt deflation and expectation effects dominate. This assessment supports the view that deflation should be avoided, and that policy should act to prevent it, rather than relying on automatic mechanisms to restore the economy. The analysis of the real balance effect therefore informs both theory and policy.
Modern perspectives
Modern analyses embed the real balance effect in models with forward-looking households and with a full set of assets. In these models, the effect operates through the wealth of households and through the intertemporal budget constraint, and its magnitude depends on the response of consumption to wealth and on the substitutability between money and other assets. The effect is one of several channels through which prices and monetary policy affect demand.
The analysis also considers the interaction of the real balance effect with other mechanisms, including the redistribution due to inflation and deflation, and the effect of monetary policy on asset prices. The modern perspective is that the real balance effect is real but modest, and that it operates alongside other channels. Understanding its magnitude and its interaction with these channels is part of the broader effort to understand the transmission of monetary policy and the behaviour of prices and demand.