Real Money Balances
What is Real Money Balances?
Real money balances (M/P) are the money supply adjusted for the price level, the purchasing power of money rather than its dollar amount.
Dividing the nominal money stock M by the price level P gives the real quantity of goods and services that money can buy. What people actually want to hold is a stable level of real balances, so if prices double, holding the same nominal money halves its real value. This is the variable on the horizontal axis of the money market in many intro and intermediate models.
Real Money Balances: a worked example
Take a nominal money stock of M = $180 billion and a price index of P = 1.20, meaning prices sit 20% above the base year. Real money balances = M/P = 180/1.20 = $150 billion measured in base-year purchasing power. Now let prices rise another 25%, to P = 1.50, while the central bank holds M fixed at $180 billion. Real balances = 180/1.50 = $120 billion. The decline is (150 - 120)/150 = 0.20, so a 25% jump in prices produced a 20% fall in real balances. To restore real balances to $150 billion at the new price level, the money supply would have to reach 150 × 1.50 = $225 billion, an increase of $45 billion in nominal money.
The mistake students make with real money balances
Percentage changes get subtracted when they should be divided. Seeing prices rise 25%, students report that real balances fell 25%, because the shortcut that the percent change in M/P equals the percent change in M minus the percent change in P feels exact. Dividing gives the real figure: 1/1.25 = 0.80, so real balances fall 20%, not 25%. The subtraction rule is only an approximation, close enough for small changes and badly off for large ones. Compute M/P at both price levels and compare the levels.
Real Money Balances questions
What is the difference between nominal and real money balances?
Nominal money balances are the dollar count, the number printed on the currency and showing in the deposit account. Real money balances divide that dollar amount by the price level to express it as purchasing power, the basket of goods the money can actually buy. Doubling everyone's cash while doubling every price leaves nominal balances twice as large and real balances unchanged. Money demand theory says households care about the real quantity, so they adjust their nominal holdings whenever the price level moves.
Why is the real money supply drawn as a vertical line?
The real money supply appears vertical because the central bank sets the nominal quantity M and the price level P is taken as given at a point in time, so M/P is a fixed number that does not respond to the interest rate. The nominal interest rate on the vertical axis has no influence on how much money has been issued. Money demand slopes downward against that vertical supply, since a higher nominal rate raises the opportunity cost of holding money, and the two cross at the equilibrium rate.
What happens to real money balances when the price level rises?
Real money balances shrink when the price level rises and the nominal money stock stays put, because the same dollars command fewer goods. On the money market graph the vertical real money supply line shifts left, which raises the equilibrium nominal interest rate and squeezes interest sensitive spending. The higher price level also cuts the real value of the money households hold as wealth, so consumption falls, and that real balances effect is one reason the aggregate demand curve slopes downward.
Formula / Example
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Common comparisons
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