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Pigou effect is an economic term referring to the relationship between employment, wealth, consumption, and output during the deflation period. According to the Pigou effect, when there is price deflation, the output (employment) increases due to a rise in wealth. That is, if wealth, is defined as the money supply divided by the levels of the current price. Alternatively, price inflation, output, and employment will go down as a result of a decrease in consumption.
A Little More on What is the Pigou Effect
The term Pigou effect was given by Don Patinkin in the year 1948, naming it after an anti-Keynesian economist, Arthur Cecil Pigou. Another term for the Pigou effect is the “real balance effect.” Pigou argued against Keynes’s theory stating that it was not enough when it comes to specifying a link from real balances to the existing consumption. His argument was that wealth effect was capable of making the economy more self-correcting to decrease in aggregate demand than what was predicted by Keynes.
Pigou’s Hypothesis and Liquidity Trap
An economy that is in the form of a liquid trap cannot make use of the monetary stimulus to increase output. The reason is that there is little link between money demand and personal income.
According to John Hicks thinking, this could be another reason for the persistently high rate of unemployment. Nonetheless, the Pigou Effect has been able to create a mechanism for evading the trap. As unemployment goes up, the price level drops hence increasing real balance causing the consumption to rise.
At full employment, the economy will move to a new environment. A conclusion by Pigou was that if wages and prices become sticky, then there will be equilibrium with the employment rate falling below the full employment rate, also known as the classical natural rate.
Pigou’s effect criticism