Pigou Effect

The Pigou effect refers to an economic theory explaining the relationship between consumption, wealth, output, and employment during a period of deflation. It aims to establish a link elucidating that an economy is more self-corrective to the alterations concerning aggregate demand compared to what was predicted by John Keynes.

This theory states that during deflation, prices decrease, which results in higher real wealth. Then, this increased wealth stimulates demand, resulting in increased output and, thus, employment. That said, in times of inflation, prices increase, wealth drops, and consumption decreases. As a result, employment and output fall. This, in turn, leads to a decrease in aggregate demand.

• The Pigou effect refers to an economic theory implying that if prices drop adequately in a slump, then the restoration of full employment would occur owing to the resulting real balance effect.
• A key difference between the Keynes effect and the Pigou effect is that the former does not account for a drop in aggregate demand through real balances. That said, the latter accounts for it.
• This concept is based on multiple factors. A noteworthy one is that the price drop leads to a surge in the money holding's real value.
• This theory attracted criticism from Michal Kalecki, a Polish economist.

The Pigou effect refers to the stimulation of employment and output because of the surging consumption resulting from an increase in the real balances of wealth, particularly during periods of deflation. This theory elucidates a relationship between economic output, consumption, and employment during inflation and deflation periods.

Economist Arthur Cecil Pigou coined this term in 1943 in an article published in the Economic Journal. The essence of this theory is that the total decrease in price level owing to a reduction in wages results in higher spending for goods and services.

One must remember that this hypothesis is based on multiple factors. Let us look at them.

• Persons hold money balances. Moreover, they spend them per a certain ratio between them.
• A decrease in prices raises the money holdings' real value.
• The excess liquid assets supply available to individuals disturbs the ratio between expenditures and balances.
• Individuals spend a portion of the excess supply available to them to purchase services and goods.

One can look at the Pigou effect diagram below to clearly understand the concept of the Pigou effect.  

An economy with a liquidity trap cannot increase output by applying monetary stimulus. According to economist John Hicks, the lack of a definitive link between personal income and money demand explains the high rates of unemployment.

Despite this, the concept of the Pigou effect in economics is a mechanism that helps in evading the liquidity trap. The price level decreases as unemployment increases. This leads to a rise in the 'real balance'. When unemployment increases, and prices decrease, individuals can purchase more with their money.

During periods of inflation, as prices increase, employment falls, and consumption increases, the purchasing power of money people already hold decreases. This reduces the possibility of individuals spending their earnings while increasing the possibility of saving more. Pigou concludes that if prices and wages become sticky, equilibrium will exist, and the rate of employment will decrease to a level below the rate of full employment.

In the IS-LM model, the liquidity trap is a phase in which an economy operates on an LM curve that is horizontal. In this case, there is no demand for bond-related investments, and individuals hoard cash anticipating events like deflation and war.

Here, monetary expansion is not able to raise the output. Hence, the output levels remain low while unemployment is high. As noted above, the Pigou Effect puts forward a system that helps escape the liquidity trap. Per this theory, unemployment rises while employment and price levels decrease.

As the price levels fall, real balances surge and consumption within the economy is stimulated via the Pigou Effect. This leads to forming a new IS-LM curve set where the LM and IS curves intersect at a higher interest rate above the portion constituting the horizontal liquidity trap. Resultantly, the economy achieves full employment equilibrium.

Let us look at this Pigou Effect example to understand the topic better.

When analyzing quantitative easing in Japan during the early 2000s, individuals can find out that if the discussion is restricted to the monetary base, its impact on demand will depend on the amount created and who was holding it. This is because the commercial banks had reserves at the nation's central bank. Such reserves' real value increased during deflation periods.

However, this would not have any significant impact on consumer spending. The consumers might have held equity in financial institutions. However, during a deflation period, every other asset in the banking sector of Japan got impaired. Hence, the total bank equity values fell, and there was no beneficial wealth effect for the households.

Michal Kalecki, a Polish economist, criticized the concept of the Pigou Effect. According to him, the adjustment Pigou proposed would catastrophically raise debts' real value. Consequently, it would result in a confidence crisis and wholesale bankruptcy. Had this been the case and the Pigou effect operated every time, Japan's central bank's close-to-zero interest rates policy would have successfully addressed the nation's deflation during the 90s.

Despite the falling prices in Japan, constant consumption expenditure went against this theory. The Japanese consumers had a tendency to delay their consumption, expecting further price declines.

Individuals new to the world of economics must know the differences between the Keynes effect and the Pigou effect to avoid any confusion regarding the two concepts. So let us look at their critical differences highlighted in the table below.

This has been a guide to what is Pigou Effect. We compare it with the Keynes effect and explain its examples, criticism, and relation with the liquidity trap. You can learn more about it from the following articles –

• Pigouvian Tax
• Real Balance Effect
• Hoover Index