What is the Pigou Effect?

The Pigou effect is 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. The Pigou effect is also known as the "real balance effect."

Key Takeaways

  • The Pigou effect states that a deflation in prices will result in increase in employment and wealth, enabling the economy to return to its "natural rates."
  • Harvard economist Robert Barro has contended that the government cannot create a "Pigou effect" by issuing more bonds.
  • The "Pigou effect" has limited applicability in explaining Japan's deflationary economy.

Understanding the 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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The Pigou Effect in History

The Pigou effect was coined by Arthur Cecil Pigou in 1943, in "The Classical Stationary State," an article in the Economic Journal. In the piece, he proposed the link from balances to consumption earlier, and Gottfried Haberler had made a similar objection the year after the General Theory's publication.

In the tradition of classical economics, Pigou preferred the idea of "natural rates" to which an economy would ordinarily return, although he acknowledged that sticky prices might still prevent reversion to natural output levels after a demand shock. Pigou saw the "Real Balance" effect as a mechanism to fuse Keynesian and classical models. In the "Real Balance" effect, higher purchasing power of money results in decreased government and investment expenditure.

However, if the Pigou effect always operated dominantly in an economy, near-zero nominal interest rates in Japan might have been expected to end the historic Japanese deflation of the 1990s sooner.

Other apparent evidence against the Pigou effect from Japan may be the extended stagnation of consumer expenditures while prices were falling. Pigou said falling prices should make consumers feel richer (and increase spending), but Japanese consumers preferred to delay purchases, expecting that prices would fall even further.

Government Debt and the Pigou Effect

Robert Barro contended that due to Ricardian equivalence in the presence of a bequest motive, the public can't be fooled into thinking they are richer than they are when the government issues bonds to them. This is so because government bond coupons must be paid for by increasing future taxes. Barro argued that at the microeconomic level, the subjective level of wealth should be lessened by a share of the debt taken on by the national government.

As a consequence, bonds should not be considered as part of net wealth at the macroeconomic level. This, he contends, implies that there is no way for a government to create a "Pigou effect" by issuing bonds, because the aggregate level of wealth will not increase.