Understanding Pigou Effect?

The Pigou effect refers to the relationship between consumption, wealth, employment, and output during periods of deflation. The Pigou effect states that when there is deflation of prices, employment (and thus output) will increase due to an increase in wealth (which increases consumption).

Prior to a period of deflation, a liquidity trap occurs, which is a period where there is zero demand for investment in bonds, and people hoard cash because they anticipate a period of deflation or war. The Pigou effect proposes a mechanism to escape this trap. According to the theory, price levels and employment fall, and unemployment rises. As price levels decline, real balances increase, and by the Pigou effect, consumption is stimulated in the economy. The Pigou effect is also known as the "real balance effect."

Arthur Pigou was an English economist who argued against Keynesian economic theory by professing that periods of deflation due to a drop in aggregate demand would be self-correcting. The deflation would cause an increase in wealth, causing expenditures to rise, thus correcting the drop in demand. Conversely, during inflation, prices rise, wealth and consumption drop, output and employment drop, and aggregate demand also goes down.

An economy that is suffering from a liquidity trap cannot apply monetary stimulus to increase output. There is no definitive link between the demand for money and personal income. According to John Hicks, this explains high unemployment rates.

Despite this, the Pigou Effect is a mechanism to evade the liquidity trap. As unemployment goes up, the price level drops. This increases the "real balance," which is the effect on spending of changes in the real value of money. People can buy more with their money when unemployment rises and prices fall.

As consumption rises, employment goes down, and prices rise. During inflation, as prices rise, the real purchasing power of the money people already hold goes down. This makes people more likely to save and less likely to spend their incomes. At full employment, the economy will be in a different place. Pigou concludes that if wages and prices become sticky, there will be equilibrium, and the employment rate will fall below the full employment rate.

The Pigou effect was coined by Arthur Cecil Pigou in 1943, in "The Classical Stationary State," which was an article in the Economic Journal. In the piece, Pigou proposed a link between "real balances" and consumption.

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