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Real Balance Effect


Development of monetary theories
Quantity Theory of money

This theory was developed by Jewish economist Don Patinkin published a book called money, interest and prices in 1956. Don Patinkin did not agree with neo-classical version of quantity theory of money on dichotomy and proportional relationship between money demand and value of money and that is only in nominal term.

Real balance effect is also known as “Patinkin effect” is developed by Jewish economist Don Patinkin by published a well-known book titled “Money, Interest and Price” in 1956. Patinkin is not against the neo-classical version on quantity theory of money which Patinkin did not agree like:

- Dichotomy
- Direct and proportional relationship between the size of cash balance and value of money
- It is made only in nominal term

Real balance effect is the process of restoring previous level of cash balance (money demand) in real term, relative prices, interest rate and full employment economy through the Pigou (wealth) effect and Keynes effect under the Keynesian transaction mechanism.

Cash balance in real term = real cash – balance

According to Patinkin, as per the “Keynesian transmission mechanism” the last input of change in money supply lies on the change in price level and there by change in cash balance in real term. So, the real balance effect helps to restore the previous level of money balance in real term, relative prices, interest rate and full employment economy. However, the real balance effect depends upon some assumptions:
  • The economy is initially functioning with full employment economy
  • Consumption function of people remains constant ( APC = C/Y and MPC = ∆C/∆Y)
  • There is no distribution effect on consumption
  • Consumption behavior of people depends upon real term not on nominal term.
  • There is no money illusion.
  • Money is neutral
  • There is no dichotomy in aggregate economy
On the the basis of given assumptions, according to Patinkin, as per the “Keynesian transmission mechanism” when money supply increases by the central bank interest rate goes down with constant money demand and thereby increase in investment, increase in effective demand, increase in income output and employment increase in cost of production and also increase in price level that leads to decrease in cash balance in real term. At this stage real balance effect starts operating to restore previous level of cash balance in real term, relative prices, interest rate and full employment economy through Pigou and Keynes effect.

 On the other hand, in product market (real sector) when cash balance in real term decreases, people feel poor than before, then they start less consumption expenditure by less demand for goods and services. Consequently, the price of goods and services also decreases and thereby increase in cash balance in real term up to the previous level which is known as Pigou effect (wealth effect).

 Similarly, in financial market when cash balance in real term decreases, people need more cash balance for transaction and precautionary motives to maintain the same level of living standard and thereby decrease in speculative money demand. Consequently, the demand for financial assets decreases and thereby decrease in financial assets, increase in interest rate, decrease in investment, decrease in income, output and employment up to the previous level which is known as the “Keynes effect”.

 In this way Patinkin has explained the Process of restoring previous level of cash balance, relative prices, interest rate and full employment. Therefore, Patinkin effect is the sum of both Pigou and Keynes effect.





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