What is Real Balance Effect?

What is Real balance effect? It is the idea that when prices rise, employment decreases, and consumption increases, the economy will self-correct. In this way, people will save money instead of spending it. Hence, a falling real purchasing power will reduce the incentive to spend. Ultimately, the economy will reach a state of equilibrium and employment will fall below full employment. This effect was first proposed by Arthur Cecil Pigou in a 1943 article in the Economic Journal.

This phenomenon affects the purchasing power of money balances in different ways, including consumption spending and the value of real assets. If the real balance declines, the purchasing power of money will decrease and so will real wealth. Ultimately, this effect is referred to as the real balance effect. But how does it affect our daily lives? Here are some examples. When we think about money and the value of goods, we will understand that it is linked to price levels.

Pigou defined real wealth as the sum of the money supply and government bonds, divided by the price level. In his argument, the absence of this link makes Keynes’ General Theory unworkable. Pigou’s analysis is known as the Real Balance effect. Its significance can be understood through comparisons between different countries. It has been found that the operative Real Balance effect gives the agents control over the price level when the nominal interest rate is zero. However, when the nominal interest rate is zero, the distributional effects of money are not positive. Therefore, it can create a situation where agents are worse off than they are today.

The real balance effect affects both the aggregate supply and the real interest rate. When prices decrease, consumers can make more purchases with cash. The real balance effect also decreases investment spending. The decrease in real wealth implies a decline in total expenditures. Hence, the higher real interest rate, the lower the consumption spending and the lower the total expenditures. However, the real interest rate decreases investment spending. This is the reason why the aggregate supply curve is not slanted downward.

The real balance effect is not a permanent phenomenon, and people do not respond to it by planning to reduce their wealth. Instead, they respond involuntarily. They will try to avoid consuming more and saving more to restore their real equilibrium. In the end, this leads to a cobweb-like approach to equilibrium. If this happens, the real balance effect may be a temporary blip, but the consequences are negative for the economy.

Rising prices are one of the causes of the real balance effect. Increasing prices reduce the purchasing power of money and accumulated financial assets. As a result, people become poorer in real terms. At the same time, the quantity demanded for real output declines. Another reason is the foreign purchases effect. When prices increase, foreigners will lessen their purchases of American exports, reducing the quantity demanded for real output.

The real balance effect is often referred to as the wealth effect, and it is the impact of price levels on asset balances. For example, if prices go down, the purchasing power of consumers’ fixed dollar assets should increase as well. Conversely, if prices rise, spending at each income level should decrease. The real balance effect explains why the relationship between the price level and the quantity demanded is inverse. This effect is particularly apparent in the context of interest rates.

The real balance effect also criticizes Keynesianism. Arthur Pigou pointed out that households have real money balances, which represent part of their household wealth. Thus, when real wealth rises, consumption increases. While the real wealth effect is often described as a negative one, it has been observed that consumers tighten their spending when market values fall. By adjusting for this, the wealth effect improves economic activity by pushing the IS curve further to the right.

In Fisher’s view, the demonstration effect is vague, and difficult to separate from other factors like media influence and exposure to capitalism. It occurs when a consumer imitates others and therefore buys the commodity to match the behaviour of others. In this model, the law of demand does not apply, because the price of a commodity does not increase if its demand goes up. If the demonstration effect is present, however, the price will increase.

In conclusion, it is important to understand the concept of Real Balance Effect and how it can be used to improve our productivity. By using this technique, we can learn to focus on one task at a time and avoid becoming overwhelmed. This, in turn, will help us to be more successful in our professional and personal lives.

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