Pantikins Real Balance Effect

In 1956 there appeared a monumental work by Don Patinkin which, inter alia, demonstrated the rigid conditions required for the strict proportionality rule of the quantity theory whilst simultaneously launching a severe attack upon the Cambridge analysis.

Patinkin’s main point of contention was that the advocates of the cash balance approach had failed to understand the true nature of the quantity theory.

Their failure was revealed in the dichotomy which they maintained between the goods market and the money market. Far from integrating the two, as had been claimed, Patinkin held that the neo-classical economists had kept the two rigidly apart.

An increase in the stock of money was assumed to generate an increase in the absolute price level but to exercise no real influence upon the market for commodities. One purpose of Patinkin’s analysis was that only by exerting an influence upon the market for commodities, via the real balance effect, could the strict quantity theory be maintained.

Part of Patinkin’s attack revolved round the nature of the demand curve for money, which according to Patinkin, Cambridge School had generally assumed to be a rectangular hyperbola with constant unit elasticity of the demand for money. As a matter of fact, such a demand curve was implicit in the argument that a doubling of the money stock would induce a doubling of the price level.

Patinkin used the ‘real balance effect’ to demonstrate that the demand curve for money could not be of the shape of a rectangular hyperbola (i.e., the elasticity of demand for money cannot be assumed to be unity except in a stationary state), and moreover, such a demand curve would contradict the strict quantity theory assertion which the Cambridge quantity theorists were trying to establish Patinkin’s main point is that cash balance approach ignored the real balance effect and assumed the absence of money illusion under the assumption of ‘homogeneity postulate’ and, therefore, failed to bring about a correct relation between the theory of money and the theory of value.

Assumptions:

Patinkin has been able to show the validity and the rehabilitation of the classical quantity theory of money through Keynesian tools with the help of and on the basis of certain basic assumptions: for example, it is assumed that an initial equilibrium exists in the economy, that the system is stable, that there are no destabilizing expectations and finally there are no other factors except those which are specially assumed during the analysis. 

Again, consumption functions remains stable [the ratio of the flow of consumption expenditure on goods to the stock of money (income velocity) must also be stable.

Further, it is assumed that there are no distribution effects, that is, the level and composition of aggregate expenditures are not affected by the way in which the newly injected money is distributed amongst initial recipients and the reaction of creditors and debtors to a changing price level offset each other. 

It is also assumed that there is no money illusion. 

Thus, Patinkin has discussed the validity of the quantity theory only under conditions of full employment, as according to him Keynes questioned its validity even under conditions of full employment.

Suppose a person holds certain money balances and price level falls, the result will be an increase in the real value of these balances. The person will have a larger stock of money than previously, in real terms, though not in nominal units. Similarly, if the private sector of the economy, taken as a whole, has money balances larger than its net debts, than a fall in the price level will lead to increased spending and the quantity theory of money to that extent stands modified, the important variable to watch is not M, but M/P, that is, real money balances. The real balance effect and the demand for money substitutes go to constitute important modifications of the quantity theory of money.

Thus, we find that the solution to this problem, as Patinkin develops it, is to introduce the stock of real balances held by individuals as an influence on their demand for goods. The real balance effect, therefore, is an essential element of the mechanism which works to produce equilibrium in the money market. Suppose, for example, that for some reason prices fall below their equilibrium level—this will increase the real wealth of the cash-holders—lead them to spend more money—and that in turn will drive prices back towards equilibrium.

Thus, the real balance effect is the force behind the working of the quantity theory. Similarly if there is a chance to increase in the price level, this will reduce people’s real balances and therefore lead them to rebuild their balances by spending less, this in turn will force prices back down, so that the presence of real balances as an influence on demands ensures the stability of the price level. Thus, the introduction of the real balance effect disposed of classical dichotomy, that is, it makes it impossible to talk about relative prices without introducing money; but it nevertheless preserve the classical proposition that the real equilibrium of the system will not be affected by the amount of money, all that will be affected will be the level of prices.

“Once the real and monetary data of an economy with outside money are specified”, says Patinkin, “the equilibrium value of relative prices, the rate of interest, and the absolute price level are simultaneously determined by all the markets of the economy.”

According to Patinkin, “The dynamic grouping of the absolute price level towards its equilibrium value will—through the real balance effect—react back on the commodity markets and hence the relative prices.” Hence, the integration of monetary and value theory through the explicit introduction of real balances as a determinant of the behaviour and the reconstitution of classical monetary theory, is the main theme and contribution of Patinkin’s monumentally scholarly work—Money, Interest and Prices.

Real Balance Effect:

The term ‘real balance effect’ was coined by Patinkin to denote the influence of changes in the real stock of money on consumption expenditure, that is, a change in consumption expenditure as a result of changes in the real value of the stock of money in circulation. This influence was taken into consideration by Pigou also under what we call ‘Pigou Effect’, which Patinkin described as a bad terminological choice. Pigou effect was used in a narrow sense to denote the influence on consumption only, but the term real balance effect, has been made more meaningful and useful by including in it all likely influences of changes in the stock of real balances.

In other words it considers the behavioural effects of changes in the real stock of money. The term has been used by Patinkin in a wider sense so as to include the net wealth, effect, portfolio effect, Cambridge effect, as well as any other effect one might think of. Patinkin used the term real balance effect to include all the aspects of real balances in the first edition of his book. It is in the second edition of his book that Patinkin emphasises the net wealth aspect of real balances though he does not completely exclude other aspects as detailed above.

Unless the term is used in a wider sense so as to include all the aspects of real balances, its use is likely to be misleading and may fail to describe a generalized theory of people’s reactions to changes in the stock of real balances. The use of the term in the wider sense as enunciated above also helps us to resolve the paradox—that income is the main determinant of expenditure on the micro level and wealth is a significant determinant of income on the macro level.

The analysis of the real balance effect listed three motives why people would alter their spending and, therefore, demand for money in response to a change in the aggregate stock of money. First, the demand for money is a function of the level of wealth. The wealthier the people, the more the expenditure on goods; second, they hold money for security as a part of their diversified portfolios; third, just as the demand for every superior good increases with a rise in income, so does the demand for money. Individuals usually desire that their cash balances should bear a given relation to their yearly income.

Therefore, other things being equal—wealth, portfolio structure and income determine the demand for money as also the spending decisions. Hence, corresponding to these three motives of the demand for money, there are three different aspects of the real balance effect—each of which may operate either directly on the demand for commodities or may operate indirectly by stimulating the demand for financial assets (securities etc.), raising their prices, lowering the interest rate, stimulating investments, increasing incomes, resulting in a rise in demand for commodities.

Neutrality of Money:

The above analysis of Patinkin’s monetary model brings to light very clearly one of the salient features of money or the quantity of money called the ‘neutrality of money’. If money is neutral, an increase in the quantity of money will merely raise the level of money prices without changing the relative prices and the interest rate. Patinkin (with the help of Keynesian framework) arrives at the classical conclusion that relative prices and the rate of interest are independent of the quantity of money.

This conclusion is easy enough to understand—whenever the public holds a combination of these kinds of money, a change in the quantity of one of them without a change in the other will change the ratios in which people are obliged to hold assets and owe liabilities. If there is a change in the amount of outside money alone without a change in the amount of inside money, there must be a change in the ratios of the debt that backs the inside money to the outside money, so that a change in the quantity of money involves a change in the real variables of the economic system, as a whole.

For example, suppose there is only outside money in an economic system like gold coins and let us suppose that the quantity of this money (gold coins) is doubled which simultaneously doubles the price level, then we get back to the initial real situation—that is, all the relative prices are the same and the ratio of real balances to everything else is the same as it was before.

Let us suppose, now that there are two kinds of money gold coins and bank deposits—suppose, we double the amount of gold coins but do not change the amount of bank deposits-—then, if we double the price level we can restore the real value of gold coins, but we will reduce the real value of bank deposits and the assets backing them, so that the community cannot get back to the situation, it started from.

Consequently, there must be some change somewhere else in the economic system to reconcile people’s desires for assets and liabilities with the changed amounts that are available. This analysis takes Gurley and Shaw several hundred pages to develop, but the key to it is, the devising of a situation in which the ratios of assets change. The whole purpose of their analysis is to show that money is not neutral. H.G. Johnson also endorses these views expressed by Gurley and Shaw on the non-neutrality of money.

Lloyd Metzler has also repudiated the neutrality of money theory with the help of general equilibrium model through IS and LM curves as shown in Fig. 29.2. In this diagram, we measure income along OY and rate of interest along vertical Or. The initial equilibrium income and the rate of interest corresponding to full employment are simultaneously determined by the intersection of IS0 and LM0 curves at income Y0 and interest r0 respectively.

Now, if the central bank follows a policy of open market operations and begins purchasing securities and bonds, the nominal stock of money will increase; this, in turn, will cause a shift in the LM function from LM1 to LM2 which will determine equilibrium at a lower rate of interest r1 and the income Y1 .There is, now, an excess of income over the full employment income.

This excess of income is shown by Y0 Y1 .This represents the inflationary gap. This will initiate a process of inflation. The real balance effect will now become operative and the LM function will shift to LM1. The IS function will also shift at the same time from IS0 to IS1, on account of a reduction in consumption spending owing to a decline in the value of real balances.

The shifting of the LM curve to LM1 and IS0 curve to IS1 will restore the equilibrium again at full employment income Y0 but the rate of interest has declined from r0 to r2. Hence, the money is not neutral (because the rate of interest cannot be considered to remain unaffected).

Unless a few conditions are fulfilled the money cannot be neutral, for example, there must be an absence of money illusion, wage-price flexibility, absence of dis-tribution effects, absence of government borrowing and open market operations and there is no combination of inside-outside money. According to Patinkin, an indi-vidual suffering from money illusion reacts to the change in money prices.

Money illusion constitutes a friction in the economic system and as such it makes it imperative for the monetary authority to create just the right amount of nominal balances if the neutrality of money is to be achieved. Similarly, flexibility of wages and prices is an important condition of the neutrality of money. Rigidity of wages and prices will prevent the real balance effect from making itself felt and hence it will become difficult to abolish inflationary pressures.

Money will, as a result, be non-neutral. The distribution effects imply the redistribution of real incomes, goods balances and bond amongst the individuals and institutions following changes in prices and stock of money. For example, a price increase may reduce the demand for consumer goods and increase the demand for money and bonds bringing about a redistribution against high consuming groups and in favour of high saving and lending groups.

Such a redistribution will mean a lowering in the rate of interest in case the quantity of money is doubled. Money, under these circumstances (unless distribution effects are absent), cannot be neutral. Again, the government borrowings and central banking open market operations have non-neutral effects on the system. Money will be non-neutral, as already seen, if there is a combination of inside-outside varieties of money.

Criticisms of Patinkina€?s Analysis of the Real Balance Effect:

Patinkin’s analysis of the real balance effect has been severely criticised by Johnson, Archibald, Lipsey, Lloyd and other economists.

1. Not Applicable in Equilibrium Situations:

Johnson points out that there is no need for the real balance effect so long as the real analysis is confined to equilibrium situations. The real balance is needed only to ensure the stability of the price level and not to determine the real equilibrium of the system.

2. Conceptually Inadequate:

Archibald and Lipsey regard Patinkin’s analysis of the real balance effect as conceptually inadequate. According to them, Patinkin traces the real balance analysis as a short-run phenomenon and does not work it out through the long-run.

3. Price Stability without Real Balance Effect:

Cliff Lloyd has criticised Patinkin for holding the classical view that people do not suffer from ‘money illusion’, and that their behaviour is influenced by the real balance effect. He has shown that the stability of the price level can be had without taking the real balance effect. According to him, by assuming that money is available in fixed quantity and people want to hold it, will bring price stability. But ‘money illusion’ will not be absent.

4. Failure to Explain Increase in Monetary Wealth:

Shaw has criticised Patinkin for his failure to analyse the manner in which the increase in monetary wealth comes about. According to him, Patinkin simply assumes a doubling of money balances and analyses only the resultant effects. In practice, money stock does not change in this manner. “Nor, in most cases, do people experience the happy variations of helicopters carrying a surfeit of bank notes. . .”

Conclusion:

Despite these criticisms, “the introduction of the real balance effect disposes of the classical dichotomy, that is, it makes it impossible to talk about relative prices without introducing money; but it nevertheless preserves the classical proposition that the real equilibrium of the system will not be affected by the amount of money, all that will be affected will be the level of prices.