Pigou effect
Encyclopedia
The Pigou effect is an economics
term that refers to the stimulation of output
and employment
caused by increasing consumption due to a rise in real balances of wealth
, particularly during deflation.
Wealth was defined by Arthur Cecil Pigou
as the sum of the money supply
and government bonds divided by the price level
. He argued that Keynes' General theory was deficient in not specifying a link from "real balances" to current 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.
He had proposed the link from balances to consumption earlier, and Gottfried Haberler
had made a similar objection the year after the General Theorys publication (http://cepa.newschool.edu/het/essays/keynes/realbalances.htm).
Following the tradition of classical economics
, Pigou favoured the idea of "natural rates" to which the economy would return, and saw the "Real Balance" effect as a mechanism to fuse Keynesian and classical models. (In most cases - he acknowledged that sticky prices might still prevent reversion to natural output levels after a demand shock
.)
could lower employment and the price level (an everyday concept in the deflationary depression
). In the IS-LM framework that Hicks bolted on to Keynesian economics
in an effort to paint Keynesianism as a trivial restatement of neoclassical economics
(and which he later disclaimed as a "classroom gadget"), a negative aggregate demand shock would shift the LM curve left due to rising real
wage
s changing liquidity preference. The Pigou effect would counterbalance this by shifting the IS curve right due to rising real balances raising expenditures.
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:
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
.
's policy of near-zero nominal interest rate
s might have been expected to end the Japanese deflation 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. A similar, reverse Pigou effect happens throughout the world in consumer electronics
because of depreciating prices (this is sometimes called the Osbourne effect).
argued that due to Ricardian Equivalence
in the presence of an operative 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 taxation. Therefore, he said that:
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
term that refers to the stimulation of output
Output
Output is the term denoting either an exit or changes which exit a system and which activate/modify a process. It is an abstract concept, used in the modeling, system design and system exploitation.-In control theory:...
and employment
Employment
Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as:- Employee :...
caused by increasing consumption due to a rise in real balances of wealth
Wealth
Wealth is the abundance of valuable resources or material possessions. The word wealth is derived from the old English wela, which is from an Indo-European word stem...
, particularly during deflation.
Wealth was defined by Arthur Cecil Pigou
Arthur Cecil Pigou
Arthur Cecil Pigou was an English economist. As a teacher and builder of the school of economics at the University of Cambridge he trained and influenced many Cambridge economists who went on to fill chairs of economics around the world...
as the sum of the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
and government bonds divided by the price level
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...
. He argued that Keynes' General theory was deficient in not specifying a link from "real balances" to current consumption
Consumption (economics)
Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...
and that the inclusion of such a "wealth effect
Wealth effect
The wealth effect is an economic term, referring to an increase in spending that accompanies an increase in perceived wealth.-Effect on individuals:...
" would make the economy more 'self correcting' to drops in aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
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 eight page Economic Journal article).He had proposed the link from balances to consumption earlier, and Gottfried Haberler
Gottfried Haberler
Gottfried von Haberler was an economist. He worked in particular on international trade....
had made a similar objection the year after the General Theorys publication (http://cepa.newschool.edu/het/essays/keynes/realbalances.htm).
Following the tradition of classical economics
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....
, Pigou favoured the idea of "natural rates" to which the economy would return, and saw the "Real Balance" effect as a mechanism to fuse Keynesian and classical models. (In most cases - he acknowledged that sticky prices might still prevent reversion to natural output levels after a demand shock
Demand shock
In economics, a demand shock is a sudden event that increases or decreases demand for goods or services temporarily. A positive demand shock increases demand and a negative demand shock decreases demand. Prices of goods and services are affected in both cases. When demand for a good or service...
.)
Integration with Keynesian Aggregate Demand
Keynes said that a drop in aggregate demandAggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
could lower employment and the price level (an everyday concept in the deflationary depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
). In the IS-LM framework that Hicks bolted on to Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
in an effort to paint Keynesianism as a trivial restatement of neoclassical economics
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...
(and which he later disclaimed as a "classroom gadget"), a negative aggregate demand shock would shift the LM curve left due to rising real
Real
Real may also refer to:* Reality, the state of things as they actually exist, rather than as they may appear or may be thought to be.-Finance:* Inflation adjusted amountsCurrencies:* Brazilian realFormer currencies:* Mexican real* Portuguese real...
wage
Wage
A wage is a compensation, usually financial, received by workers in exchange for their labor.Compensation in terms of wages is given to workers and compensation in terms of salary is given to employees...
s changing liquidity preference. The Pigou effect would counterbalance this by shifting the IS curve right due to rising real balances raising expenditures.
Why Pigou's hypothesis prevents the liquidity trap
An economy in a liquidity trapLiquidity trap
A liquidity trap is a situation described in Keynesian economics in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as...
cannot use monetary stimulus to increase output because there is little connection between personal income and money demand, John Hicks
John Hicks
Sir John Richard Hicks was a British economist and one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economics were his statement of consumer demand theory in microeconomics, and the IS/LM model , which...
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 rateInterest rateAn interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
threshold of the liquidity trap. - Finally, the economy moves to the new equilibrium, at full employmentFull employmentIn macroeconomics, full employment is a condition of the national economy, where all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so....
.
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
Sticky (economics)
Sticky, in the social sciences and particularly economics, describes a situation in which a variable is resistant to change. Sticky prices are an important part of macroeconomic theory since they may be used to explain why markets might not reach equilibrium right away. Nominal wages are often said...
.
Kalecki's criticism of the Pigou effect
The Pigou effect was criticized by Kalecki because 'The adjustment required would increase catastrophically the real value of debts, and would consequently lead to wholesale bankruptcy and a " confidence crisis."'The Pigou effect and Japan
If the Pigou effect always operates strongly, the Bank of JapanBank of Japan
is the central bank of Japan. The Bank is often called for short. It has its headquarters in Chuo, Tokyo.-History:Like most modern Japanese institutions, the Bank of Japan was founded after the Meiji Restoration...
's policy of near-zero nominal interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s might have been expected to end the Japanese deflation 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. A similar, reverse Pigou effect happens throughout the world in consumer electronics
Consumer electronics
Consumer electronics are electronic equipment intended for everyday use, most often in entertainment, communications and office productivity. Radio broadcasting in the early 20th century brought the first major consumer product, the broadcast receiver...
because of depreciating prices (this is sometimes called the Osbourne effect).
Government debt and the Pigou effect
Robert BarroRobert Barro
Robert Joseph Barro is an American classical macroeconomist and the Paul M. Warburg Professor of Economics at Harvard University. The Research Papers in Economics project ranked him as the 4th most influential economist in the world as of August 2011 based on his academic contributions...
argued that due to Ricardian Equivalence
Ricardian equivalence
The Ricardian equivalence proposition is an economic theory holding that consumers internalize the government's budget constraint: as a result, the timing of any tax change does not affect their change in spending...
in the presence of an operative 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 taxation. Therefore, he said 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.
- Bonds should not be considered as part of net wealth at the macroeconomic level.
- Therefore: There is no way for the government to create a "Pigou effect" by issuing bonds, because the aggregate subjective level of wealth will not increase.
External links
- History of the extensions of the original Pigou effect into more generalized "Wealth effectWealth effectThe wealth effect is an economic term, referring to an increase in spending that accompanies an increase in perceived wealth.-Effect on individuals:...
s". - Liquidity Traps... Is Japan Really Trapped at the Zero Bound? 2002 Kobe University analysis of the deflationary spiral, points out that an "insatiable liquidity preferenceLiquidity preferenceIn macroeconomic theory, Liquidity preference refers to the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money to explain determination of the interest rate by the supply and demand...
" neutralizes the Pigou effect, and that theory would then indicate persistent deflationary stagnation (below full employment). Paul KrugmanPaul KrugmanPaul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
'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.)