The Real Balance Effect
The Real Balance Effect in economics has its origins in the work of Cecil Pigou in the 1930s and 40s. In essence that work was intended as a sort of add-on to Keynes' ideas in his 'General Theory', but it also challenged that theory in some important ways.
We should recall that Keynes's work came as a response to the Great Depression of the 1930s, and was a sort of critique of Classical economics insisting that, left to its own devices, a free-market economy would result in a deflationary recession with persistently high unemployment as a natural consequence of that recession.
The natural prelude to that period of deflationary depression is usually thought to be a period of zero (or near zero) interest rates whereby the Federal Reserve loses its ability to boost the economy via a monetary stimulus package. This is a situation known as the 'liquidity trap', and Pigou's Real Balance Effect presents a counter-argument to this situation by showing that even when interest rates are zero, monetary policy can still have an influence on the economy.
In this article I will explain this idea, sometimes called the 'Pigou Effect', in more detail. The basic idea is quite simple and doesn't need much prior understanding, but to fully appreciate the concept it is advisable to become acquainted with the theory surrounding it. As a minimum you will need to understand how the IS-LM Model works, so be sure to read up on that.
Throughout the article I'll also link to some of the other key economic concepts that relate to the Real Balance Effect, because it does form a fundamental dividing line between some of the main schools of economic thought.
The Pigou Effect vs The Keynes Effect
As you will have noticed from my opening paragraphs, there is some controversy about the workings of Keynes' general theory in certain situations. As is often the case, much of the disagreement is less about direct refutation and more about timeframe. Keynesians are primarily focused on the short-term while their main opponents (the classical economists) look more at the long-term.
The question often boils down to how long the long-term is and whether or not it is long enough to justify some sort of government intervention rather than just leaving the free market to fix itself.
With its focus on the short-term, the Keynes effect describes how (holding all other factors constant) a falling price level will increase the purchasing power of any given money supply, and (as explained in my article about the LM Curve) this causes real balances to shift rightwards along the money demand curve, intercepting it at a new, lower interest rate. The effect of this is to create a rightward shift of the LM curve which, in normal times, will intercept a downward sloping IS Curve at a higher national income.
However, this gives rise to two theoretical possibilities where national income is not affected. The first occurs when the IS curve is vertical, the second occurs when the LM curve is horizontal.
I have already explained the case of a horizontal LM curve on my page about the liquidity trap, so see that article for details. Here I will explain the vertical IS curve problem.
In the graph below we start with the left side where a falling price level from P1 to P2 increases the purchasing power of a given money supply. The extra purchasing power is illustrated as a rightward shift of the real balance line (M/P). This new line intercepts the downward sloping money demand line (L) at a lower interest rate (from R1 down to R2).
On the right side of the graph we show that the LM curve (which plots equilibrium in the money markets) shifts to the right as a result of the extra purchasing power of the money supply. In normal times the LM curve would intercept a downward sloping IS curve with an interest rate in between R1 and R2, and with an increased national income. This is the 'Keynes effect', but with a vertical IS curve national income remains unaffected and the Keynes effect does not work.
This means that a downturn in the economy i.e., a fall in national income, which causes prices to fall (i.e. deflation) will not self-correct, and monetary policy is ineffective. Keynes favored government intervention in the form of fiscal stimulus in such circumstances.
The Pigou Effect
The real balance effect, also called the Pigou effect (a term first coined by the economist Don Patinkin in 1948), contradicts the Keynes effect by arguing that the analysis above is not complete, and that there is another step to add in that the IS curve itself will eventually push rightwards as a result of the falling price level. This will occur in the case of a liquidity trap or a vertical IS curve.
In other words, even if a lower interest rate fails to boost investment spending via the Keynes effect, the goods market itself should gradually see some extra spending due to the lower prices. If this happens then national income will gradually recover any loss and the interest rate will gradually climb until its initial rate is restored.
The important question relates to how long this extra step will take, and if it will happen at all.
Keynesians argue that some prices in the economy, particularly wages, are sticky and reluctant to move downwards. This would mean that falling profit margins would not easily be offset by falling labor costs and thus it would take a long time for economic output to recover. Additionally, many economists believe that falling prices make consumers reluctant to spend more even though the purchasing power of their money increases as prices fall i.e. the 'wealth effect'. They argue that falling prices makes consumers hold off on spending today in anticipation of even lower prices at a later date.