Real balances

What Is Real Balances?

Real balances refer to the quantity of money held by individuals and firms, adjusted for the effects of inflation. It is a core concept in macroeconomics that measures the true purchasing power of a given amount of currency. While the nominal amount of money in your wallet or bank account remains constant, its real balance fluctuates with changes in the overall price level. Economists use real balances to understand how changes in prices affect the actual wealth and spending capacity of economic agents, which in turn influences aggregate demand and overall economic growth.

History and Origin

The concept of real balances gained prominence in economic thought, particularly through the work of economists like Arthur Cecil Pigou. Pigou, building on earlier classical traditions, formalized the idea that changes in the real value of money balances could influence consumption and thus the economy. His "Pigou effect," also known as the real balance effect, posits that a decline in the general price level, such as during deflation, increases the real value of money holdings, making individuals feel wealthier and encouraging them to spend more. This mechanism, discussed in his 1943 article "The Classical Stationary State," was a response to certain aspects of Keynesian theory and aimed to show how an economy might be self-correcting in the face of demand shocks. The Federal Reserve Bank of St. Louis provides further insights into the historical development and implications of the Pigou effect.¹²

Key Takeaways

• Real balances measure the purchasing power of money holdings, adjusting for inflation or deflation.
• They are crucial for understanding how changes in prices affect individual and aggregate spending.
• The concept highlights that holding nominal amounts of money does not guarantee stable purchasing power over time.
• Central banks monitor real balances to assess the effectiveness of monetary policy and its impact on the economy.
• Fluctuations in real balances can significantly influence consumer behavior and investment decisions.

Formula and Calculation

Real balances are calculated by dividing the nominal money supply (M) by the aggregate price level (P). This relationship can be expressed as:

Where:

• (M) represents the nominal quantity of money in circulation or held by the public (e.g., money supply measures like M1 or M2).¹¹
• (P) represents the aggregate price level, often measured by an index such as the Consumer Price Index (CPI) or the Personal Consumption Expenditures (PCE) price index.¹⁰

This formula demonstrates that for a given nominal quantity of money, an increase in the price level (inflation) reduces real balances, while a decrease in the price level (deflation) increases them.

Interpreting Real Balances

Interpreting real balances involves understanding their implications for economic activity. When real balances are high, individuals and businesses possess greater purchasing power, which tends to stimulate consumption and investment. Conversely, when real balances decline, perhaps due to unexpected inflation, economic agents feel less wealthy and may reduce their spending, impacting overall economic activity. This sensitivity of spending to real balances is a fundamental component of the wealth effect. Changes in expected inflation rates can also influence the demand for real balances, as individuals may choose to hold more or less money depending on its anticipated future purchasing power.⁹

Hypothetical Example

Consider an individual, Sarah, who has $10,000 in her checking account at the beginning of the year. This represents her nominal balance. At that time, let's assume the Consumer Price Index (CPI), representing the average price level of goods and services, is 100. Her real balance would be:

Now, suppose by the end of the year, due to inflation, the CPI rises to 105, while Sarah's nominal balance remains $10,000. Her real balance at the end of the year would be:

Even though Sarah still has $10,000 in her account, the real balances have declined from 100 to approximately 95.24 units. This demonstrates that her money can now buy fewer goods and services than it could at the beginning of the year, highlighting the erosion of purchasing power due to rising prices.

Practical Applications

Real balances are a vital concept in various aspects of economics and finance. In monetary policy, central banks like the Federal Reserve closely monitor real balances and the price level to gauge the effectiveness of their actions in achieving price stability. For instance, if a central bank increases the money supply, the goal is often to increase real balances and stimulate economic activity, assuming prices do not rise proportionally. However, if inflation erodes these nominal increases, the real impact is diminished.⁸ The Federal Reserve's commitment to price stability is a testament to the importance of maintaining the real value of money for the economy.⁷

Real balances also play a role in formulating economic models, such as the Quantity Theory of Money, which links the money supply, velocity of money, price level, and output. Understanding real balances helps economists analyze money demand and predict the effects of monetary changes on the economy.

Limitations and Criticisms

While the concept of real balances is fundamental, it faces certain limitations and criticisms. One major critique relates to situations of extreme inflation, such as hyperinflation. In such scenarios, the price level can rise so rapidly that the real value of money holdings collapses almost instantaneously, leading to a loss of public confidence in the currency.⁶ For example, during periods of hyperinflation in Zimbabwe, the rapid devaluation of the local currency severely impacted the real balances held by citizens, making it difficult to conduct even basic transactions. This highlights that while the formula for real balances remains the same, its practical relevance diminishes when prices are highly unstable.³, ⁴, ⁵

Furthermore, the "real balance effect" (Pigou effect) has been criticized for assuming that individuals primarily perceive their wealth in terms of nominal money balances rather than other assets. In an economy burdened by significant debt, a sharp fall in prices could increase the real value of debt, potentially leading to widespread bankruptcies and a confidence crisis that outweighs any positive effect from increased real money balances. The effectiveness of the real balance effect in stimulating consumption during deflation has also been questioned, particularly in contexts like Japan's prolonged period of falling prices, where consumers sometimes delayed purchases anticipating further price declines rather than increasing spending.²

Real Balances vs. Nominal Balances

The distinction between real balances and nominal balances is crucial for understanding the true economic impact of money.

While nominal balances represent the numerical amount of currency an individual possesses, real balances reveal what that nominal amount can actually buy. For instance, if you hold $500 (a nominal balance), its real balance—its actual value in terms of goods and services—will decrease if prices rise (inflation) and increase if prices fall (deflation). Understanding this difference is fundamental to assessing the impact of monetary policy and inflation on a household's financial well-being.

FAQs

Why are real balances important?

Real balances are important because they provide a true measure of the purchasing power of money. They indicate how much goods and services a given amount of currency can acquire, which is vital for understanding consumer behavior, investment decisions, and the overall health of an economy in the face of inflation or deflation.

How do real balances relate to inflation?

Real balances have an inverse relationship with inflation. When inflation occurs, the general price level rises, reducing the purchasing power of each unit of currency. Consequently, for a fixed nominal amount of money, the real balances — the actual value of that money — decline.

What is the real balance effect?

The real balance effect, also known as the Pigou effect, suggests that a decrease in the general price level (deflation) increases the real value of money balances held by individuals. This increase in real wealth can then stimulate consumption and aggregate demand, acting as a mechanism to restore economic equilibrium.

Do real balances affect interest rates?

Changes in real balances can influence interest rates. According to the Fisher Effect, the nominal interest rate is the sum of the real interest rate and the expected inflation rate. If changes in real balances influence expectations about future inflation, they can indirectly impact nominal interest rates. Additionally, the demand for real balances interacts with the supply of money to determine equilibrium interest rates in money markets.¹