The Pigou effect describes how consumption, wealth, employment, and production are connected during deflation. It suggests that when prices fall, wealth rises, leading to more consumption and, in turn, more jobs and higher production.
Before deflation happens, a liquidity trap can occur. This is when there is no interest in investing in bonds, and people keep cash because they expect deflation or conflict. The Pigou effect suggests a way out of this trap. It states that as prices and jobs decrease, unemployment goes up. When prices drop, real money balances rise, which encourages spending in the economy. The Pigou effect is also called the “real balance effect.”
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Arthur Pigou was an English economist who disagreed with Keynesian economic theory. He believed that when there is deflation from a decrease in overall demand, the economy would fix itself. This deflation would lead to more wealth, which would increase spending and help restore demand. On the other hand, during inflation, prices go up, wealth and spending decrease, leading to lower production and jobs, which also reduces overall demand.
An economy in a liquidity trap cannot use monetary stimulus to boost production. There is no clear connection between the demand for money and individual income. John Hicks suggests that this is why unemployment rates are high.
The Pigou Effect helps to avoid a liquidity trap. When unemployment increases, prices tend to decrease. This leads to a rise in “real balance,” meaning people can spend more because their money’s real value has increased. As unemployment rises and prices drop, people can afford to buy more.
When consumption increases, unemployment decreases, and prices start to rise. During inflation, as prices go up, the real value of the money people have decreases. This situation encourages people to save rather than spend their income. At full employment, the economy will be in a different state. Pigou suggests that if wages and prices are slow to adjust, there will be a balance, but the employment rate may remain below the full employment level. So What is Pigou Tax?