Define real money balances. Explain the supply and demand for real money balances. What is the relationship between income and transaction, precaution, and speculative motives for holding real money balances? Explain the effects of fiscal and monetary policies on IS-LM. What are 'feedback effects?' In macroeconomics, the money supply (or money stock) refers to the total volume of money held by the public at a particular point in time in an economy. A perfectly inelastic curve such as the real money supply curve also indicates that the real quantity of money (m 1) does not vary with the real interest rate (r). This particular real money supply curve implies that the central bank focuses on the quantity of money as the monetary policy tool. Real Money Supply. Money supply expressed in base-year dollars, calculated by dividing the money supply by a price index. Related Terms: Accomodating Policy. A monetary policy of matching wage and price increases with money supply increases so that the real money supply does not fall and push the economy into recession. After-tax real rate of return. Money after-tax rate of return minus the inflation. The choice between these alternative definitions of the money supply depends on two considerations: One, “a particular choice of definition may facilitate or blur the analysis of the various motives for holding cash;” and two from the point of view of monetary policy an appropriate definition should include the area over which the monetary authorities can have direct influence.

The previous article was an introduction about the two basic decisions that corporate finance helps a corporation in making. Prima-facie, these two decisions may look pretty simple. After all everyone raises money in their daily lives and puts it to productive use. Simple accounting can tell us whether or not we should make those financing and investing decisions. So, why is there a need for a complicated subject called corporate finance to make these decisions? Well, it turns out there is a need? The need arises because of this concept of nominal and real value of money. This article will explain why corporate finance is required:

The Concept of Inflation

We are all intuitively aware of the concept of inflation. We know that money loses its value every year. The same amount of money will purchase less and less every year. Let’s say that $100 is required to purchase a certain commodity of goods today. So if there is an inflation of 10%, the same goods will be available for a $110 next year.

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Introduction to Nominal Value of Money

So, if we made an investment that was yielding 9% return this year, we would have a total of $109 next year from the $100 we had invested. In accounting terms we would have a profit of $9. This is because we are only considering the nominal values. Nominal values do not consider the effect of inflation, opportunity cost of capital and such other forces which cause the value of money to decrease in a given time period.

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The Problem with Nominal Values to Measure a Firm’s Performance:

Nominal values present a distorted image of the firm’s performance to its shareholders and this is to say the least. Consider the case we discussed above. Here, the firm has lost 1% purchasing power. This means they were better off consuming the $100 in year 1 and could have purchased more goods with it rather than investing it and consuming $109 a year later. Thus, if nominal values are considered, firms will end up eroding their capital by investing their money in projects that offer a rate of return that is below the firm’s cost of capital.

Introduction to Real Value of Money

To offset this problem, specialists in corporate finance have come up with the concept of real value of money. The real value of money takes into account inflation, opportunity cost of capital and such other forces. Thus, firms that base their calculations on these inflation adjusted values make better financial decisions as compared to those that do not. The calculation for both real as well as nominal values is simple and can be done with the help of the following formula:

Real Value = Nominal Value / (1 + (i / 100))

Define Real Money Supply

i = The prevailing inflation rate in the market

Subjectivity in Real Value of Money:

It must be understood that the real and nominal values of money are subjective. This is because, they are determined using the inflation rate. There is no single measure of inflation. The government itself produces multiple estimates of inflation. Also, for the purpose of the company’s calculation, these measures may not be good enough. So the company may create its own inflation index depending on which the real values are calculated. Thus, there is widespread subjectivity in this calculation. Different companies use different rates to convert nominal values to real values.

The biggest take-away from the concept of nominal and real values is that money in one time period is not directly comparable to money in another time period. It is for this reason we have to calculate present values, future values and the like. These calculations form the backbone of corporate finance.

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