Pigou Effect

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DEFINITION of 'Pigou Effect'

A term in economics referring to the relationship between consumption, wealth, employment and output during periods of deflation. Defining wealth as the money supply divided by current price levels, the Pigou effect states that when there is deflation of prices, employment (and thus output) will be increased due to an increase in wealth (and thus consumption).

Alternatively, with the inflation of prices, employment and output will be decreased, due to a decrease in consumption.

Also known as the "real balance effect."

BREAKING DOWN 'Pigou Effect'

Arthur Pigou, for whom this effect was named, argued against Keynesian economic theory by professing that periods of deflation due to a drop in aggregate demand would be more self-correcting. The deflation would cause an increase in wealth, causing expenditures to rise, and thus correcting the drop in demand.

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