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3.4.3 The Pigou effect

Pigou was one of the last great classical economists who spoke for the

classical school in the 1940s (for example, 1941, 1943, 1947) arguing that,

providing money wages and prices were flexible, the orthodox Keynesian

model would not come to rest at less than full employment equilibrium. The

Pigou effect (see, for example, Patinkin, 1948, for a classic discussion) concerns

the effect that falling prices have on increasing real wealth, which in

turn increases consumption expenditure. Suppose, as is the case in Figure

3.7, the economy is at underemployment equilibrium (Y0) in the liquidity trap

at point E0, the intersection of IS0 and LM0. As prices fall, not only will the

LM curve shift outwards to the right (from LM0 to LM1) as the real value of

the money supply increases, but the IS curve will also shift to the right, from

IS0 to IS1, as the resultant increase in real wealth increases consumption

expenditure. In theory the economy cannot settle at underemployment equilibrium

but will automatically adjust until full employment is achieved at

point E1, the intersection of IS1 and LM1. The reader should verify that, once

the Pigou or wealth effect on expenditure is incorporated into the analysis, in

the special interest-inelastic investment case illustrated in Figure 3.8 the

economy will automatically adjust to restore full employment, at point E2.

The importance of the Pigou effect at the theoretical level has been neatly

summarized by Johnson (1964, p. 239): ‘the Pigou effect finally disposes of

the Keynesian contention that underemployment equilibrium does not depend

on the assumption of wage rigidity. It does.’

Over the years a number of reservations have been put forward which

question whether, in practice, the Pigou or wealth effect will ensure a quick

return to full employment (see, for example, Tobin, 1980a). In what follows

we consider two of the main criticisms of the effect. First, dynamic considerations

may invalidate the Pigou effect as a rapid self-equilibrating

mechanism. For example, if individuals expect a further future fall in prices,

they may postpone consumption, causing unemployment to rise. At the same

time, if firms expect a recession to continue, they may postpone their investment

plans, again causing unemployment to rise. Furthermore, in a deep

recession bankruptcies are likely to increase, reducing expenditure still further

(see, for example, Fisher, 1933b). In terms of the diagrammatic analysis

we have been considering, falling prices may cause the IS curve to shift to the

left, driving the economy further away from full employment equilibrium. In

these circumstances expansionary fiscal policy would ensure a more rapid

return to full employment.

Second, we need to consider briefly the debate on which assets constitute

‘net’ wealth. Net wealth can be defined as total wealth less outstanding

liabilities. In the Keynesian model wealth can be held in money and bonds.

Consider first money, which is widely accepted as comprising currency plus

bank deposits. Outside money can be defined as currency, plus bank deposits

which are matched by banks’ holdings of cash reserves or reserves at the

central bank. Outside money may be considered as net wealth to the private

sector as there is no offsetting private sector liability. In contrast, inside

money can be defined as bank deposits which are created by lending to the

private sector. As these bank deposits are matched by a corresponding private

sector liability (bank loans), it can be argued that inside money cannot be

regarded as net wealth. It is worth noting that the argument that inside money

does not constitute net wealth has been challenged by, among others, Pesek

and Saving (1967) and Johnson (1969). While this is an interesting debate

within monetary economics, it goes beyond what is required for our purposes.

Suffice it to say that, if one accepts the argument that only outside

money unambiguously constitutes net wealth, the wealth effect of falling

prices on consumption expenditure is greatly diminished. Next, as noted

earlier, in section 3.3.3, there is debate over whether government bonds can

be regarded as net wealth. It could be argued that the private sector will

realize that, following a fall in prices, the increase in the real value of

government debt outstanding will necessitate future increases in taxes to

meet the increased value of interest payments on, and redemption of, government

bonds. If the rise in the present value of future tax liabilities exactly

offsets the increase in the real value of government debt outstanding there

would be no wealth-induced shift in the IS curve. Again, while this view is

not one that is universally accepted, it does nevertheless cast doubt on the

self-equilibrating properties of the economy via the Pigou effect. The empirical

evidence for the strength of the Pigou effect shows it to be extremely

weak. For example, both Glahe (1973, pp. 213–14) for the USA and Morgan

(1978, pp. 55–7) for the UK found that the Pigou effect was not strong

enough to restore full employment in the interwar period, with actual price

level falls taking place alongside a decline in expenditure and output. Furthermore,

on reasonable assumptions, Stiglitz (1992) has shown that, if prices

were to fall by 10 per cent per year, then ceteris paribus ‘to increase consumption

by 25 per cent would take roughly 400 years’ and ‘it is hard to see

even under the most optimistic view, the quantitative significance of the real

balance effect for short-run macroeconomic analysis’. Given such doubts,

orthodox Keynesians prescribe expansionary fiscal policy to ensure a more

rapid return to full employment.

Finally it is interesting to quote Pigou (1947), who suggested that the

‘puzzles we have been considering … are academic exercises, of some slight

use perhaps for clarifying thought, but with very little chance of ever being

posed on the chequer board of actual life’.