Posted by: Dirk | December 16, 2008

Deflation and the Pigou effect

The following is coming from the History of Economic Thought website:

The implication of this new consumption function should be clear. In situations of unemployment, as money wages and price levels decline, then the real money supply rises (the Keynes effect) which, as we saw, shifts the LM curve to the right. However, the “Pigou Effect” (or “Real Balance” effect) implies that as M/p rises, so does V and consequently consumption rises as well – shifting the IS curve to the right. Thus, Pigou (1943) proposed, even the “special cases” of a liquidity trap or interest-insensitive investment are not sufficient to maintain unemployment equilibrium as the rightward shifts of the IS curve via the “Pigou Effect” will ensure we are taken to full employment equilibrium. Thus, the only possible way to have unemployment equilibrium in a Keynesian model is if there are sticky wages and prices, period.

This can be expressed differently, as by

The Pigou effect is the wealth effect on consumption as prices fall. A lower price level leads to a greater existing private wealth of nominal value, leading to a rise in consumption.

The following news, coming from the NYT, must then be good:

Retail prices fell at their fastest rate on record in November as oil prices continued to tumble and retailers and auto dealers slashed their prices to woo back anxious consumers.

The Labor Department reported Tuesday that consumer prices fell 1.7 percent in November from the month before, led downward by tumbling energy prices, which fell 17 percent over one month as the demand for gasoline and oil eclipsed.

If the Pigou effect operates, falling prices would increase consumption. But apparently, this is not so (Stephen Roach, again from the NYT):

IT’S game over for the American consumer. Inflation-adjusted personal consumption expenditures are on track for rare back-to-back quarterly declines in the second half of 2008 at a 3.5 percent average annual rate. There are only four other instances since 1950 when real consumer demand has fallen for two quarters in a row. This is the first occasion when declines in both quarters will have exceeded 3 percent. The current consumption plunge is without precedent in the modern era.

This is an interesting development and will lead to some reevaluation of historical debates. Basically, this says that it (Keynesian theory) is not about sticky prices. So, the macroeconomic debate was mislead a long time ago and should be put on the right track again. Re-reading more of Keynes’ General Theory over Xmas sounds like an incredibly good idea to me.


  1. Read Mises or Hayek instead.


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s


%d bloggers like this: