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enter image description hereI am a beginner at economics and am reading Mishkin's famous book The Economics of Money, Banking and Financial Markets(eleventh edition). In chapter 12, Page 271, when the author analyzed the causes of financial crises, he said that "an unanticipated decline in the price level will lead to deterioration in firms' net worth". His argument is the following: Consider a firm with assets and debts, since the debt payments are contractually fixed in nominal terms, an unanticipated decline in the price level raises the value of borrowing firms and households liabilities in real terms but does not raise the real value of their assets. The borrowers' net worth in real terms (the difference between assets and liabilities in real terms) thus declines.

I am quite confused that why the real value of assets does not change? Does the author assume here that the firm only have fixed assets that does not change with the price level? But if the firm have some loans then the value of these part of assets will decrease?

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A real asset has some physical characteristics that determine what real output it will produce. E.g.; an orchard produces apples, a construction company creates buildings, etc.

Say my real asset has produces 1 unit of real output per year, and at the previous price level this was worth \$10,000. Now that the price level dropped, the same 1 unit of real output may only be worth \$9,000, that is how much it can be sold for.
At the same time, my debts were in nominal, not real terms, e.g.; perhaps I had to pay \$10,000 per year. This is not affected by the price level, because there is no real output behind it, only a purely monetary agreement.

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  • $\begingroup$ P.s.: I find the claim "an unanticipated decline in the price level will lead to deterioration in firms' net worth" too general. I am sure there are cases when this is true for the majority of the firms, but I am not convinced that the nice sounding logic I put in my answer covers all real life cases. I find that macro textbooks are frequently problematic like this. $\endgroup$
    – Giskard
    Commented Sep 16, 2023 at 13:46

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