Monetary Economics, Theory of Money, absolute prices vs. relative prices

1. PATINKIN’S REAL
BALANCE EFFECT
Prof. Prabha Panth
Osmania University,
Hyderabad

2. Pricing in Classical and Neo-classical
theory
• Classical theory – Real sector and goods.
Relative prices based on real D and S.
• Neo-classical theory – monetary sector, with
absolute prices, given by Quantity theory of
money. SM then Ps 
• Relative prices are thus separated from absolute
prices.
• Dichotomy in pricing between Classical and
Neo-classical theories.
• Relative Ps and Absolute Ps are not inter related.
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3. Neutrality of Money
• How to reconcile Relative Ps (value) and
Money theory of prices?
• When QM it is assumed that all prices 
proportionally, so relative prices will not
change.
– This is the assumption of Homogeneity
– Also known as Neutrality of Money.
• If money is neutral, classical theory can be
accepted that there is no relation between
relative prices and absolute prices.
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4. Patinkin’s theory
According to Patinkin, the classical dichotomy is
invalid.
Relative Ps are affected by money Ps, because:
1) SM affects equilibrium in the commodity sector,
Because P the real value of cash balance ,
and people will spend less.
Demand for goods falls.
D for commodities < S of commodities. So
prices will fall
But DM (cash balance) , with excess DM
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5. 2. The absolute or Money price depends on
SM in the economy.
If SM doubles, Absolute Ps will also
double.
So Absolute Ps will not remain stable.
3. In Neo Classical theory, when Ps, D for
goods , but DM  proportionately.
But SM is constant.
So excess DM leads to fall in the Price
level.
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6. • Thus changes in SM leads to change in
Absolute Prices.
• D for goods is dependent on Absolute Prices.
• D for goods changes with change in SM.
• Therefore there is connection between
Relative Ps and Absolute Ps.
• So the Classical Dichotomy is invalid,
• The real economy will not be in equilibrium if
there is change in Money Supply.
Dichotomy is invalid
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7. • Equilibrium in the Real Economy can be
restored even if money S changes.
• This can be done by making D and S
functions depend on:
1) The real value of cash balance, and
2) The relative prices.
This is done through the Real Balance
Effect.
Patinkin’s Real Balance Effect
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8. • According to Patinkin, the Real Balance
Effect can lead to equilibrium in the
Money Market.
• But this has been ignored by the Neo-
classical theory.
–If P, the real value of Cash Balance .
–So DM , and D for goods ,
–As D for goods , Ps will also .
–Therefore Equilibrium will be restored.
• The opposite happens when
–Ps , DM , but D for goods .
–Finally Ps will fall.
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9. • Therefore, the Real Balance effect leads to
stability in the P level.
• Thus Real Balance Effect removes the
Classical Dichotomy, by showing the inter
relationship between D and S of money and
commodities.
• But it also shows that Real Equilibrium of
Classical theory can be achieved when D and
S of Money changes.
• The Relative Prices will not change, but the
Level of Absolute Prices will change.
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