Patinkin’s Analysis of the Real Balance Effect (With Criticisms)

In this article we will discuss about Patkin’s analysis of the real balance effect with its criticisms.

Don Patinkin in his monumental work Money, Interest and Prices criticises the Cambridge economists for the homogeneity postulate and the dichotomisation of goods and money markets and then reconciles the two markets through the real balance effect.

The homogeneity postulate states that the demand and supply of goods are affected only by relative prices. It means that a doubling of money prices will have no effect on the demand and supply of goods. Mathematically, the demand and supply function for goods are homogeneous of degree zero in prices alone.

Thus this homogeneity postulate precludes the price level from affecting the goods market as well as the money market. Patinkin criticises this postulate for its failure to have any determinate theory of money and prices.

Another closely related assumption which Patinkin criticises is the dichotomisation of the goods and money markets in the neo-classical analysis. This dichotomisation means that the relative price level is determined by the demand and supply of goods, and the absolute price level is determined by the demand and supply of money. Like the homogeneity postulate, this assumption also implies that the price level has absolutely no effect on the monetary sector of the economy, and the level of monetary prices, in turn, has no effect on the real sector of the economy.

After condemning the neo-classical assumptions outlined above, Patinkin integrates the money market and the goods market of the economy which depend not only on relative prices but also on real balances. Real balances mean the real purchasing power of the stock of cash holdings of the people.

When the price level changes, it affects the purchasing power of people’s cash holdings which, in turn, affects the demand and supply of goods. This is the real balance effect. Patinkin denies the existence of the homogeneity postulate and the dichotomisation assumption through this effect. For this, Patinkin introduces the stock of real balances (M/P) held by community as an influence on their demand for goods.

Thus the demand for a commodity depends upon real balance as well as relative prices. Now if the price level rises, this will reduce the real balances (purchasing power) of the people who will spend less than before. This implies a fall in the demand for goods and the consequent fall in prices and wages.

The price decline increases the value of money balances held by the people which, in turn, increases the demand for goods directly. The initial decrease in commodity demand creates a state of involuntary unemployment. But unemployment will not last indefinitely because as wages and prices fall, the real balance effect tends to increase commodity demand directly and indirectly through the interest rate. With sufficiently large fall in wages and prices, the full employment level of output and income will be restored.

Finally, even if there is the “liquidity trap”, the expansion of the money supply Will increase money balances and full employment can be restored through the operation of the real balance effect. According to Patinkin, “This is the crucial point. The dynamic grouping of the absolute price-level towards its equilibrium value will—through the real balance effect—react on the commodity markets and hence on relative prices.”

Thus absolute prices play a crucial role not only in the money market but also in the real sector of the economy. Patinkin further points out that “once the real and monetary data of an economy with outside money are specified, the equilibrium values of relative prices, the rate of interest, and the absolute price level are simultaneously determined by all the markets of the economy.” In this way, Patinkin also introduces the real balance effect in the general equilibrium analysis.

Besides removing the classical dichotomy and the homogeneity postulate and integrating the monetary and value theory through the real balance effect, Patinkin also validates the quantity theory conclusion. According to Patinkin, the real balance effect implies that people do not suffer from ‘money illusion’. They are interested only in the real value of their cash holdings.

In other words, they hold money for ‘what it will buy’. This means that a doubling of the quantity of money will lead to a doubling of the price level, but relative prices and the real balances will remain constant and the equilibrium of the economy will not be changed.

The real balance effect is illustrated, diagrammatically in Fig. 1 by using the IS and LM technique because the IS curve represents the goods market and the LM curve the money market. To begin with, we take a situation when the economy is in equilibrium at OY₁ level of income when the IS and LM curves intersect at point A where the interest rate is Or₁. Assuming OY_F as the full employment level, the pressure of unemployment-is measured by Y₁-Y₁ which causes wages and prices to fall simultaneously.

This results in an increase in the real value of people’s money holdings which shifts the LM curve to the right to LM₁. It intersects the IS curve at point B the income level OY₂ with the result that the interest rate falls to Or₀ which stimulates investment, discourages savings and increases consumption.

Even when the interest rate falls to its minimum level Or₀, the level of demand in the commodity market as represented by the IS curve is not high enough to lead the economy to the full employment level OY_F. Rather, unemployment measured by Y₂-Y, remains in the economy. This much unemployment leads to a further fall in wages and prices, and to the increase in demand for consumption goods which shifts the IS curve to the right to IS₁ so that it intersects the LM₁, curve at point C at the full employment level OY_F.

Thus under conditions of wage and price flexibility when the IS and LM curves shift rightwards, the real balance effect ultimately leads the economy to full employment level, even in the liquidity trap situation as shown above when investment is interest inelastic.

Conclusion:

Thus the real balance effect demonstrates three theoretical points: first, it eliminates the classical dichotomy between value and monetary theory; second, it validates the conclusions of the quantity theory that in equilibrium, money is neutral and the interest rate is independent of the quantity of money through the real balance effect; and third, the wage-price flexibility leads to full employment in the long-run and that the Keynesian underemployment equilibrium is a disequilibrium situation.

Criticisms of Patinkin’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.”