The Pigou Effect is a theory proposed by the famous anti-Keynesian economist, Arthur Pigou. It explains a relationship between consumption, employment, and economic output during times of deflation and inflation. According to Pigou, during deflation, prices are low, which leads to greater real wealth. The increased wealth then stimulates demand, leading to a rise in output and, consequently, employment. On the other hand, during inflation, prices rise, wealth falls, consumption falls, and hence, output and employment decline, leading to a drop in aggregate demand.
Also known as the “Real Balance Effect,” the Pigou Effect essentially proposes that any increase or decrease in aggregate demand will be self-correcting. The main argument Pigou emphasizes is the lack of any link between real balances and current consumption in the General Theory of Keynes. His real balance effect theory tries to provide a link that explains the economy as being more self-correcting to changes in aggregate demand than what John Keynes predicted.
The Liquidity Trap
Liquidity trap, in the IS-LM model, is that phase when the economy is operating on a horizontal LM curve. Here, there is zero demand for investment in bonds and people hoard cash due to expectations of events such as war or deflation.
Here, monetary expansion fails to increase output. There are very low levels of output and high unemployment. 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 in the economy is stimulated. This creates a fresh set of IS-LM curves, where the IS curve intersects the LM curve above the horizontal liquidity trap portion at a higher interest rate. Consequently, the economy attains full employment equilibrium. Pigou’s conclusion was that the economy would operate on an equilibrium less than the full employment equilibrium only if prices and wages were constant.
Arguments and Criticisms
In the IS-LM framework of Keynes, which was formalized by British economist John Hicks, any adverse aggregate demand shock would shift the IS curve leftwards, and the LM curve would shift rightwards because of the simultaneous falls in wage and price levels. This is the Keynes Effect. The Pigou Effect, on the contrary, accounts for a fall in the aggregate demand via rising real balances, which raises expenditure via the income effect.
Polish economist Michal Kalecki criticized the Pigou effect. According to him, the adjustment proposed by Pigou “would increase catastrophically the real value of debts, and would consequently lead to wholesale bankruptcy and a confidence crisis.”
The Bank of Japan’s policy of nearly zero interest rates would’ve been successful in addressing the Japanese deflation in the 1990s if the Pigou effect did actually always operate. Constant consumption expenditure in Japan despite falling prices goes against the Pigou effect. Japanese consumers tended to develop a sentiment to delay consumption in anticipation of further declines in prices.
Who was Arthur Pigou?
Arthur Cecil Pigou was a British anti-Keynesian welfare economist in the 20th century. Pigou played a key role in the foundation of the School of Economics at the University of Cambridge. He greatly contributed to the field of welfare economics and public finance, which included the business cycle, the Pigou Effect, the Pigovian Tax, index numbers, and measurement of national output. Many of his works were used by other influential economists as their basis to put forward contrasting views to Keynesian economics. Pigou received the Chancellor’s Gold Medal and the Adam Smith Prize in 1899 and 1903, respectively. Keynes was very critical of Pigou, mentioning him 17 times in his book “The General Theory of Employment, Interest, and Money.”
Learn more about economics and finance
Thank you for reading this guide to the Pigou Effect. To keep learning and advancing your career in corporate finance, CFI has developed numerous online courses and resources to teach you what you need to know about economics, finance, and Excel.
One of the most important skills for a financial analyst is financial modeling, the art of building an abstract representation of a company and it’s future performance.