|This article needs additional citations for verification. (April 2011)|
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.
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 had made a similar objection the year after the General Theory's publication ().
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.)
Integration with Keynesian Aggregate Demand
Keynes said that a drop in aggregate demand could lower employment and the price level (an everyday concept in the deflationary depression). In the IS-LM framework of Keynesian economics a negative aggregate demand shock would shift the LM curve left due to rising real wages 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 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 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
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).
Government debt and the Pigou effect
Robert Barro 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:
- 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.
- Pigou, Arthur Cecil (1943). "The Classical Stationary State". Economic Journal 53 (212): 343–351.
- Kalecki, Michael (1944). "Professor Pigou on the "Classical Stationary State" A Comment". The Economic Journal 54 (213): 131–132.
- Barro, Robert J. (1974). "Are Government Bonds Net Wealth?". Journal of Political Economy 82 (6): 1095–1117. doi:10.1086/260266.
- History of the extensions of the original Pigou effect into more generalized "Wealth effects".
- 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.)