The Pigou Effect is an economics term that describes what happens in the economy, particularly with the aggregate consumption, if prices fall. It is an effect that deals with economic wealth.
The Pigou effect says that ...
...as prices fall, more money becomes available to consumers for spending (greater private wealth in nominal value) whose purchases create demand for more production (a rise in consumption) and hence create more jobs and economic growth.
The Pigou effect describes the impact of a change in the money supply on consumption.
The citizens who feel wealthier as a result of price level decrease increase their demand for consumer goods. Thus the overall economic demand rises.
Implicit in the Pigou effect was the belief that an improved employment situation was achievable through lower wages.
The Pigou effect refers to the stimulation of output and employment caused by increasing consumption particularly during deflation periods.
How does the Pigou effect show on the ISxLM model?
The Pigou effect can be shown in diagrammatic form as a shift in the IS curve to the right.
The Pigou effect in the real world
The Pigou effect rarely works in real world. It is because, if a fall in prices is steep enough, many firms will commence their existence drowning some banks with them. That would happen because they would not be able to pay their debts.
If the fall in prices is gradual, people and firms would not know where it will stop and both consumers and producers would hold on to their cash, thus creating a liquidity trap.
The Pigou effect is hardly observable because prices rarely fall in any economy. One economy that came close to deflation was Japan.
Japan's history may serve as evidence against the Pigou effect. Japan experienced long period of stagnating consumer expenditures while prices were falling.The Pigou effect says that falling prices would make consumers feel richer and increase spending, but Japanese consumers reported that they preferred to delay purchases, expecting that prices would fall further.
A similar effect, called a reverse Pigou effect can be observed throughout the world in consumer electronics because of depreciating prices (this is sometimes called the Osbourne effect).
The history of the Pigou effect
The Pigou effect was described for the first time by English economist Arthur Cecil Pigou (1877-1959).
The Pigou effect belongs to the classical school of economics and was subsequently surpassed by the work of English economist John Maynard Keynes (1883-1946).
Alternative name to the Pigou effect
The Pigou effect is also known as the real balance effect.