Real Balances

Published Sep 8, 2024

Definition of Real Balances

Real balances refer to the purchasing power of the money holdings of individuals or institutions, taking into account the effects of inflation. That means real balances represent the quantity of goods and services that can be purchased with a given amount of nominal money, adjusted for changes in price levels. Real balances decline as prices rise and increase as prices fall.

Example

Imagine Jane has $1,000 in her savings account. This amount represents her nominal balances. If the average price level of the goods and services Jane purchases rises due to inflation, the purchasing power of her $1,000 – her real balances – declines. For instance, if the price level increases by 10%, Jane will need $1,100 to buy the same quantity of goods and services she could previously purchase for $1,000. Thus, her real balances have effectively decreased. Conversely, if the price level falls, Jane can buy more with her $1,000, increasing her real balances.

Why Real Balances Matter

Real balances are crucial for understanding the true value of money and the economic well-being of individuals and organizations. Policymakers and economists closely monitor real balances because they directly affect consumption, savings, and investment decisions. When inflation erodes purchasing power, individuals may reduce their consumption and increase their demand for higher wages, which can lead to inflationary spirals. On the other hand, stable or increasing real balances can boost consumer confidence and spending, driving economic growth.

Frequently Asked Questions (FAQ)

How can individuals protect their real balances from inflation?

Individuals can protect their real balances from inflation by investing in assets that typically appreciate in value or generate returns that outpace inflation. Common strategies include investing in stocks, real estate, or other tangible assets, and purchasing inflation-protected securities such as Treasury Inflation-Protected Securities (TIPS). By maintaining a diversified investment portfolio, individuals can hedge against the eroding effects of inflation and preserve their real balances.

How do central banks influence real balances in the economy?

Central banks influence real balances through monetary policy tools aimed at controlling inflation and stabilizing the economy. By adjusting interest rates and conducting open market operations, central banks can influence the money supply and, consequently, the inflation rate. For example, raising interest rates can cool down an overheated economy and reduce inflationary pressures, helping to maintain or increase real balances. Conversely, lowering interest rates can stimulate economic activity but may also lead to higher inflation if not managed properly.

Are there any indicators that can help predict changes in real balances?

Several economic indicators can help predict changes in real balances, including:

• Inflation Rate: The Consumer Price Index (CPI) and the Producer Price Index (PPI) are key measures of inflation that affect real balances. Rising inflation typically reduces real balances, while falling inflation can increase them.
• Interest Rates: Changes in interest rates, set by central banks, impact inflation and consequently real balances. Monitoring interest rate decisions and announcements from central banks can provide insights into potential changes in real balances.
• Money Supply: The growth rate of the money supply, measured by indicators like M1 and M2, can signal future inflationary trends that will affect real balances.
• Economic Growth: GDP growth rates can indicate the overall health of the economy and potential inflationary pressures, influencing real balances indirectly through changes in income and demand for goods and services.

Can real balances impact income inequality?

Yes, real balances can have a significant impact on income inequality. Inflation often disproportionately affects lower-income individuals, who spend a higher percentage of their income on essential goods and services. As inflation erodes the purchasing power of money, these individuals may find it more challenging to maintain their standard of living, exacerbating income inequality. Conversely, wealthier individuals with diversified investments and assets that appreciate in value may see their real balances preserved or even grow, further widening the gap between different income groups.