Subject: Economics

Class: M.A.
Semester: III
Name of the Paper:
Monetary Economics

Topic:
The Real Balance Effect (Part III)

Sub-Topic:
Patinkin’s Integraton of the Monetary Theory and the Value Theory

Keywords: real balance, wealth effect, Patinkin, commodity market, money market.

Dr. Rajesh Pal

Professor and Head
Department of Economics
Faculty of Social Sciences
Mahatma Gandhi Kashi Vidyapith
Varanasi-02.
Email: [email protected]

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provided in this chapter is correct and accurate in regard to the subject matter covered. The matter of this
chapter is taken from the author’s book entitled “Issues and Concepts of Economics (2016),” published by
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Copyright © 2020 by Rajesh Pal.

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 The Real Balance Effect (Part III)
Patinkin’s Integraton of the Monetary and Value Theory

Learning Objectives

After learning this chapter, you will be able to:

• Understand the meaning of real balance effect.

• Explain Patinkin’s integraton of the monetary and value theory

Introduction

The real balance refers to the effect of changes in the value of real cash balance held by the
public. Real balance equals stock of money (i,e., money issued by government and central bank)
divided by price level. We can write real balance as, R = , where, R refers to real balance; M
represents outside money i.e., money issued by the central bank or the government, which are
not considered as a part of the public. Since M is liability of the government and asset of the
public, is part of the real net wealth of the public and any changes in it produces wealth effect;
and P denotes price level.

The real balance was first introduced by Pigou to defend Say’s law of markets (supply
creates its own demand) against Keynes’ attack. Patinkin has used it to integrate the monetary
and real sectors and thereby to rehabilitate the classical quantity theory of money.

Patinkin’s Integraton of the Monetary and Value Theory

Professor Patinkin’s integration of value theory with monetary theory and with the theory of
employment is a highly impressive architectonic accomplishment, based on a single fundamental
idea. The idea is that of interpreting the demand for real balances held as resulting from the
utility or safety yielding quality of the balances. This analytical device is analogous to the
deviation of the demand for the consumer goods from their utility.

The author first incorporates the demand for real balances (money balances deflated for
the price level) into the theory of consumer choice on the level of micro analysis. Thus, room is
made in the system for what Patinkin calls the “real balance effect’1

The classical quantity theory of money maintains a dichotomy between the monetary
sector and the real sector. It (classicist) assumes that money is a neutral (the classical
economists’ belief that changes in the money supply affect the general price level, but not
relative price. Relative price refers to any price expressed as a ratio of another price) and having
no influence on output, which is governed by real variables like labour, capital, and technology.

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An increase in money supply increases absolute price level without affecting relative prices,
which are determined in the real sector. Patinkin has rejected the classical dichotomy between
the monetary sector and the real sector in his monumental work, “Money, Interest, and Prices
(1965)”. He argued that dichotomy between monetary sector and real sector is inconsistent with
the quantity theory of money.

Don Patinkin (1954) challenged the classical dichotomy as being inconsistent, with the
introduction of the ‘real balance effect’ of changes in the nominal money supply.

According to Patinkin, an increase in the quantity of money first influences the demand
for the commodities and their relative prices through real balance effect and then the absolute
prices. Thus, Patinkin has attempted to integrate the monetary sector with the real sector through
the real balance effect. He postulated that the existence of a real balance effect in real sectors
integrates monetary and real sector.

The early classical writers postulated that money is inherently equivalent in value to that
quantity of real goods, which it can purchase. Therefore, in Walrasian terms, a monetary
expansion would increase prices by an equivalent amount, with no real effects on employment
on output and employment. Patinkin postulated that this inflation could not come about without a
corresponding disturbance in the goods market. As the supply of money increases, the real stock
of money balances exceeds and thus, the expenditure on good rises, which establish the optimum
balance. The rise in price level in the goods market will continue until excess demand is
satisfied, at the new equilibrium. He thus argued that the classical dichotomy was inconsistent in
that it did not allow for this adjustment in the goods market2.

Don Patinkin’ real balance effect theory is based on the following assumptions:

1. Money could not change the real magnitudes of economic variables. That is they
believe in neutrality of money;
2. Expectations are unit elastic;
3. All prices are flexible;
4. No distribution effect exists; and
5. There is no money illusion.

Patinkin believe that when price level changes, it affects the purchasing power of the
people; the real purchasing power of the people is real money balance, which people hold in the
form of cash balances, which ultimately affect the demand for goods and services. This is the
real balance effect.

If the price level increases, real money balances decreases (i.e., purchasing power of
money reduces). The reduction in real money balances will have two effects: (i) demand for
commodity will be reduced, (ii) wages and prices will fall (because demand for commodities
reduces). The initial decline in demand for commodities will generates involuntary

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unemployment but this type of unemployment will not last for long time because decline in
demand for commodities will reduce wages and prices and reduction in prices and wages will
increase real
al money balances. This real money balance effect tends to increase demand directly
or indirectly through the interest rate. With sufficiently large fall in prices and wages, full
employment level of income and output will be restored.

Patinkin’s general
al equilibrium model considers three markets:

1. Commodity market;
2. Labour market; and
3. Money market.

The commodity market and labour market comprises together, which is called real
sector market. The real balance effect of Don Patinkin is illustrated in the Figure
Fi 1, in which rate
of interest (i) is shown on vertical axis and income or output (Y) on horizontal axis. In Figure 1,
at income level, Y, IS and LM represents equilibrium between interest rate

and income in the goods market and money market respecti respectively.
vely. Initially, economy is in
equilibrium level of output at point E, where both IS and LM curve intersects each other at Y =
22.50 level of output. Assuming that full employment level of output is at YF = 55. The pressure
of unemployment (i.e., difference between Y and YF) would depress wage rates and fall in
prices. This results into an increase in real balances, which shifts the LM curve to the right to

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LM1 (see Figure 1). The LM1 curve intersects IS curve at low rate of interest (i) at point E1 at
Y1 level of output. Falling interest rate will stimulate investment as a result income will increase
but note that there is still unemployment (i.e., the difference between Y1 and YF) in the economy
at Y1 level of output. This leads to a further fall in wages and prices and consequent an increase
in demand for consumer goods. Increase demand boost up investment and this leads to shift in
the IS curve to IS1, which intersects LM2 at point E2 resulting into full employment level of
output (YF). Thus, the rightward shift of the IS and LM curve ultimately leads to economy to full
employment level, even in a situation when the interest rate falls to minimum level. This shows
that money is neutral and the interest rate is independent of the quantity of money through the
real balance effect.

In summary, we can say that the Don Patinkin,s real balance effect theory: (i) eliminates
dichotomy between monetary sector and real sector; (ii) it validates the conclusion of the
quantity theory in equilibrium money is neutral and interest rate is independent of the quantity of
the money through the real balance effect; (iii) wage-price flexibility leads to full employment in
the long-run and that the Keynesian underemployment equilibrium is a disequilibrium situation.

Terminology

• Real Sector Market: The commodity market and labour market comprises together,
which is called real sector market.
• Pigou Effect: The Pigou effect is also known as wealth effect, was propounded by
Arthur C. Pigou in 1943 to counter Keynes’ argument that wage-price deflation cannot
leads to automatic full employment.

Important Points

• Real balance equals stock of money (i,e., money issued by government and central bank)
divided by price level.
• The real balance was first introduced by Pigou to defend Say’s law of markets (supply
creates its own demand) against Keynes’ attack.
• Patinkin has attempted to integrate the monetary sector with the real sector through the
real balance effect. He postulated that the existence of a real balance effect in real sectors
integrates monetary and real sector.
• Relative price refers to any price expressed as a ratio of another price) and having no
influence on output, which is governed by real variables like labour, capital, and
technology.
• Patinkin’s general equilibrium model considers three markets: (i) Commodity market, (ii)
Labour market, and (iii) Money market.

Check Your Progress

1. Explain the concept of real balance effect.

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 2. Explain Patinkin’s real balance effect.
3. Discuss Patinkin’s Integraton of the Monetary Theory and the Value Theory

References

1. William.Fellener, Patinkin’s integration of monetary and value theory”, The American

Economic Review, Vol.46, No.5, Dec. 1956
2. Don Patinkin, 1987, “Neutrality of Money”, The New Palgrave: A Dictionary of
Economics, v.3,pp.639-644.

Note: See part I and II for the Pigou Effect.