Pigou Effect

What Is the Pigou Effect?

The Pigou effect refers to the relationship between consumption, wealth, employment, and output during periods of deflation. The Pigou effect states that when there is deflation of prices, employment (and thus output) will increase due to an increase in wealth (which increases consumption).

Prior to a period of deflation, a liquidity trap occurs, which is a period where there is zero demand for investment in bonds, and people hoard cash because they anticipate a period of deflation or war. 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 is stimulated in the economy. The Pigou effect is also known as the "real balance effect."

Understanding the Pigou Effect

Arthur Pigou was an English economist who argued against Keynesian economic theory by professing that periods of deflation due to a drop in aggregate demand would be self-correcting. The deflation would cause an increase in wealth, causing expenditures to rise, thus correcting the drop in demand. Conversely, during inflation, prices rise, wealth and consumption drop, output and employment drop, and aggregate demand also goes down.

Image by Sabrina Jiang © Investopedia 2020

An economy that is suffering from a liquidity trap cannot apply monetary stimulus to increase output. There is no definitive link between the demand for money and personal income. According to John Hicks, this explains high unemployment rates.

Despite this, the Pigou Effect is a mechanism to evade the liquidity trap. As unemployment goes up, the price level drops. This increases the "real balance," which is the effect on spending of changes in the real value of money. People can buy more with their money when unemployment rises and prices fall.

As consumption rises, employment goes down, and prices rise. During inflation, as prices rise, the real purchasing power of the money people already hold goes down. This makes people more likely to save and less likely to spend their incomes. At full employment, the economy will be in a different place. Pigou concludes that if wages and prices become sticky, there will be equilibrium, and the employment rate will fall below the full employment rate. 

History of the Pigou Effect

The Pigou effect was coined by Arthur Cecil Pigou in 1943, in "The Classical Stationary State," which was an article in the Economic Journal. In the piece, Pigou proposed a link between "real balances" and consumption.

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. With the real balance effect, higher purchasing power results in decreased government and investment expenditure.

However, critics of the Pigou effect note that if the effect was always operating in an economy, the near-zero nominal interest rates in Japan in the 1990s might have been expected to end the historic Japanese deflation sooner than they did.

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, a Harvard economist, contended that due to Ricardian equivalence, the public can't be fooled into thinking they are richer than they are when the government issues bonds to them. This is because government bond coupons must be paid for by increasing future taxes. Ricardian equivalence is an economic theory that says that financing government spending out of current taxes or future taxes (and current deficits) will have equivalent effects on the overall economy. Barro argued that at the microeconomic level, the subjective level of wealth should be lessened by the national government assuming a share of the debt.

As a consequence, bonds should not be considered part of net wealth at the macroeconomic level. This, he contended, 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.

The Pigou Effect did not play out in Japan in the 1990s when the country was experiencing economic stagnation and historic  deflation.

Criticism of the Pigou Effect

The Keynes Effect holds that as prices fall, a nominal money supply will be associated with a larger real money supply, causing interest rates to fall. This will stimulate investment and spending on physical capital and boost an economy. The implication is that insufficient demand and output will be resolved by lower price levels.

The Pigou Effect, on the contrary, accounts for a fall in the aggregate demand via rising real balances. People have more money to spend if prices fall, which raises expenditure via the income effect.

Polish economist Michal Kalecki was a critic of 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.”

If this were the case, and the Pigou effect always operated, The Bank of Japan’s policy of nearly zero interest rates would have been successful in addressing the Japanese deflation in the 1990s. Thus, the constant consumption expenditure in Japan despite falling prices goes against the Pigou effect. In the case of Japanese consumers, they anticipated further price declines and delayed consumption.

Pigou FAQs

What Is a Pigovian Tax?

A Pigovian (Pigouvian) tax is a tax assessed against private individuals or businesses for engaging in activities that have adverse societal effects and costs. The costs of the side effects are not included as a part of the product's market price. For example, the cost of coal energy is environmental pollution, the cost of tobacco production are strains on public healthcare. The purpose of the Pigovian tax is to redistribute the cost back to the producer or user of the negative externality. A carbon emissions tax or a tax on plastic bags are examples of Pigovian taxes.

How Do Marshall, Coase, and Pigou Differ in Their Treatment of Externalities?

Pigou extended Alfred Marshall's concept of externalities as costs imposed or benefits conferred on others that are not taken into account by the person taking the action. Pigou argued that the existence of externalities is sufficient justification for government intervention. Pigou suggested that negative externalities (costs imposed) should be offset by a tax, while positive externalities should be offset by a subsidy. Ronald Coase argued with Pigou's analysis in the early 1960s suggesting that "taxes and subsidies are not necessary if the partners in the transaction — that is, the people affected by the externality and the people who cause it — can bargain over the transaction."

How Did Pigou Challenge the Free Market?

Pigou challenged the free market by suggesting that the government should intervene and tax private companies and individuals for the negative effects their operations have on society. For example, Pigou believed that polluters should be taxed and health insurance should be compulsory.