THE REAL-BALANCE EFFECT: ASPECTS AND EVIDENCE*

Abstract

POSTKEYNESLAN MONETARY THEORY has explained the of changes in the real money supply in three basic ways. They may be termed the effect (generally called the real-balance effect), the portfolio-balance effect, and the Cambridge effect. According to the net-wealth effect, an increase in the money supply increases the assets of the private sector but not its liabilities, since fiat money is a liability of the government. As a result of this increase in wealth, private spending increases. Since government spending is assumed constant, total spending for goods and services increases as a result of the increase in the net wealth of the private sector. The result of the increase in net wealth, assuming full employment, is an equiproportional rise in the price level.' According to the portfolio effect, variations in an area's stock of money affect expenditures when real balances bear a proportion to the value of the portfolio which is different from the proportion desired by money holders. Rearrangement of portfolios takes place through additional spending or additional accumulation, processes which drive prices either up or down and restore the actual value of money holdings to the desired value. Finally, the Cambridge views individual decisions about money holdings as depending upon yearly income. If money holdings represent a fraction of yearly income that is larger (say) than people desire, they remedy the situation by increasing their rate of expenditure, causing an increase in the price level. It is our contention that the only realistic way in which to make the real-balance (RBE) a useful concept with which to analyze the workings of the economy is to define it as the set of all changes in spending behavior resulting from a change in the real stock of money and to include, as aspects of the RBE, the three effects mentioned above. Moreover, there should be a recognition of the fact that excess supply of money may imply an excess demand for financial instruments as well as for commodities. In other words, an overall view of the of changes in real balances must admit that changes in the money supply affect interest rates, investment, and incomes, as in the Keynes effect. Hence, we also include this as the indirect aspect of the RBE. In our view, an increase in the real money supply increases spending for both consumption goods and financial instruments, with the ultimate increase in spending stemming not only from whatever wealth argument enters the consumption function, but also from whatever extra income is generated through increased investment and lower interest rates.