Editing Pigou effect

{{short description|Economic phenomenon and term by Arthur Cecil Pigou}}
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{{missing|whether there is a consensus among modern economists that this effect is real|date=August 2019}}
In [[economics]], the '''Pigou effect''' is the stimulation of [[Output (economics)|output]] and [[employment]] caused by increasing consumption due to a rise in real balances of [[wealth]], particularly during [[deflation]]. The term was named after [[Arthur Cecil Pigou]] by [[Don Patinkin]] in 1948.<ref>{{Cite journal|jstor = 591|title = Price Flexibility and Full Employment|last = Patinkin|first = Don|date = September 1948|journal = The American Economic Review|pages = 543–564|volume = 38|issue = 4|author-link = Don Patinkin}}</ref><ref>{{Cite journal|jstor = 1825073|title = An Asset Influence in the Labor Market|last = Hough|first = Louis|date = June 1955|journal = Journal of Political Economy|doi = 10.1086/257665|issue = 3|pages = 202–215|volume = 63|s2cid = 154553746}}</ref><ref>{{Cite journal|url = http://hope.econ.duke.edu/node/134|title = Managing the Loss: How Pigou Arrived at the Pigou Effect|last = Takami|first = Norikazu|date = April 2011|journal = HOPE Center Working Papers|access-date = 2014-07-15|archive-date = 2019-05-14|archive-url = https://web.archive.org/web/20190514200347/https://hope.econ.duke.edu/node/134|url-status = dead}}</ref>

Real wealth was defined by [[Arthur Cecil Pigou]] as the summation of the [[money supply]] and [[government bonds]] divided by the [[consumer price index|price level]]. He argued that [[John Maynard Keynes|Keynes]]' ''[[The General Theory of Employment, Interest and Money|General Theory]]'' was deficient in not specifying a link from "real balances" to current [[Consumption (economics)|consumption]] and that the inclusion of such a "[[wealth effect]]" would make the economy more "self correcting" to drops in [[aggregate demand]] than Keynes predicted. Because the effect derives from changes to the "Real Balance", this critique of [[Keynesianism]] is also called the '''Real Balance effect'''.

== History ==
The Pigou effect was first popularised by Arthur Cecil Pigou in 1943, in ''The Classical Stationary State'' an article in the ''[[Economic Journal]]''.<ref name=Pigou43>{{cite journal |last=Pigou  |first=Arthur Cecil |author-link=Arthur Cecil Pigou |year=1943 |title=The Classical Stationary State |journal=Economic Journal |volume=53 |issue=212 |pages=343–351 |jstor= 2226394 |doi=10.2307/2226394}}</ref> He had proposed the link from balances to consumption earlier, and [[Gottfried Haberler]] had made a similar objection the year after the ''General Theory'''s publication.<ref>{{Cite web |url=http://cepa.newschool.edu/het/essays/keynes/realbalances.htm |title=Real Balances Debate |access-date=2005-05-12 |archive-url=https://web.archive.org/web/20050624075216/http://cepa.newschool.edu/het/essays/keynes/realbalances.htm |archive-date=2005-06-24 |url-status=dead }}</ref>

Following the tradition of [[classical economics]], Pigou favoured the idea of "natural rates" to which the economy would return in most cases, although he acknowledged that [[Sticky Prices|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.

== Integration with Keynesian aggregate demand ==
Keynes argued with that a drop in [[aggregate demand]] could lower both employment and the price level in unison, an occurrence observed in the [[deflation]]ary [[Great Depression|depression]]. In the [[IS-LM]] framework of [[Keynesian economics]] as formalised by [[John Hicks]], a negative aggregate demand shock would shift the IS curve left; as a result, a simultaneously falling wage and price level would shift the LM curve downward due to a rising real money supply - this is referred to as the [[Keynes effect]]. The Pigou effect would in turn counter the fall in aggregate demand, through rising current real balances raising expenditures via the [[Income effect]], thus shifting the IS curve back towards the right.

== Pigou's hypothesis and the liquidity trap ==
An economy in a [[liquidity trap]] cannot use [[monetary]] stimulus to increase output because there is little connection between personal income and money demand. John Hicks thought that this might be another reason (along with sticky prices) for persistently high unemployment. However, the Pigou effect creates a mechanism for the economy to escape the trap:

# As unemployment rises,
# the price level drops,
# which raises real balances,
# and thus consumption rises,
# which creates a different set of IS-curves on the [[IS-LM]] diagram, intersecting the LM curves above the low [[interest rate]] threshold of the liquidity trap.
# Finally, the economy moves to the new equilibrium, at [[full employment]].

Pigou concluded that an equilibrium with employment below the full employment rate (the classical natural rate) could only occur if prices and wages were sticky.

== Kalecki's criticism of the Pigou effect ==
The Pigou effect was criticized by [[Michał Kalecki]] because "The adjustment required would increase catastrophically the real value of debts, and would consequently lead to wholesale bankruptcy and a confidence crisis."<ref name=Kalecki44>{{cite journal|last=Kalecki |first=Michael  |author-link=Michael Kalecki  |year=1944  |title=Professor Pigou on the "Classical Stationary State" A Comment. |journal=The Economic Journal |volume=54 |issue=213 |pages=131–132 |jstor= 2959845 |doi=10.2307/2959845}}</ref>

== The Pigou effect and Japan ==
If the Pigou effect always operated strongly, the [[Bank of Japan]]'s policy of near-zero nominal [[interest rate]]s might have been expected to end the [[History of Japan#The 'Lost Decade'|Japanese deflation]] of the 1990s sooner.

Other apparent evidence against the Pigou effect from Japan may be its long period of stagnating consumer expenditure whilst prices were falling. Pigou hypothesised that falling prices would make consumers feel richer (and increase spending) but Japanese consumers tended to report that they preferred to delay purchases, expecting that prices would fall further.

== Government debt and the Pigou effect ==
[[Robert Barro]] argued that due to [[Ricardian equivalence]] in the presence of a bequest motive, the public is not fooled into thinking they are richer when the government issues bonds to them, because government bond coupons must be paid from increased future taxation.<ref name=Barro74>{{cite journal|last=Barro|first=Robert J.|author-link=Robert J. Barro|year=1974 |title=Are Government Bonds Net Wealth? |journal=Journal of Political Economy |volume=82 |issue=6 |pages=1095–1117 |doi=10.1086/260266 |s2cid=154705295|url= http://dash.harvard.edu/bitstream/handle/1/3451399/Barro_AreGovernment.pdf?sequence=4}}</ref> Therefore, he argued that at the microeconomic level, the subjective level of wealth would 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 implies that there is no way for the government to create a "Pigou effect" by issuing bonds, because the aggregate level of wealth will not increase.

==See also==
*[[Keynes effect]]

==References==
{{Reflist}}

== External links ==
* [https://web.archive.org/web/20050425003457/http://www.newschool.edu/cepa/conferences/papers/050415_klein_the-wealth-effect.pdf History of the extensions of the original Pigou effect] into more generalized "[[Wealth effect]]s".
* [http://www.rieb.kobe-u.ac.jp/academic/ra/dp/English/dp127.pdf Liquidity Traps... Is Japan Really Trapped at the Zero Bound?] 2002 Kobe University analysis of the deflationary spiral, argues that an "insatiable [[liquidity preference]]" neutralizes the Pigou effect, and that theory would then indicate persistent deflationary stagnation (below full employment). [[Paul Krugman]]'s description of a liquidity trap resistant to the Pigou effect is also mentioned. (His advocacy of long-term inflationary [[JPY]] policies was partly based on dismissing the '''Pigou effect'''.)

[[Category:Economics effects]]