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Pigou Effect

 Pigou Effect
  • The Pigou effect also identified as the wealth effect was advocated by A.C Pigou to oppose Keynes' dispute that wage price depression cannot lead to regulation full employment.
  • Pigou fully identified that interest rate effect of Keynes that wage price deflation hikes investment and earnings through a decline in the interest rate.
  • But he did not agree that the actual earnings cannot be mounted to a level of full employment due to liquidity entrap.
  • As per Pigou, a wage price deflation will create automatic via enhancement in the level of consumption. He argued that when money wages are cut, prices drops and the value of money rises.
  • The rise in the value of money means a rise in the actual value of assets such as stocks, shares, bank deposits, government securities, bonds etc.
  • For instance, if prices drop by fifty percentages, the actual value of each dollar will be twofold for the reason that it will purchase two times as much as it did before.
  • They will hence, save less out of their present earnings and expend mechanically full employment in the financial system.
  • This will hike total demand and total output and will create mechanically full employment in the financial system.
  • Consequently, the Pigou effect the terms of the IS function means a rightward move of the IS curve.

Now let us see arithmetically how the Pigou effect occurs.

  • Arithmetically, if the money supply which is presumed to be invariable is Mo and the price level is P1 then the saving function (or consumption function) will be S = f [RY (M0 / P)], thus saving S is based on the interest rate R, earnings Y and the ratio of given money supply to complete prices (M0 / P).
  • When prices drops, the actual value of a given stock of money hikes and people diminish their saving or enhance consumption thus enhancing total demand.
  • This procedure will mechanically tend the fiscal system to the level of full employment when reduce in remuneration and prices discontinues.

  • In Pigou effect, interest elasticity and points of the saving and investment operations are immaterial. The Pigou effect is presented diagrammatically below.
  • To start with the diagram (1) presumes the financial system is at Y1 level of earnings as ascertained by IS1 and LM0 curves at E1.
  • Now remuneration price deflation commences which mounts the consumption function such that the IS1 curve moves rightward to IS2.

  • Specified the LM0 curve the IS2 curve overlaps the LM0 curve at E2 thus mounting the earnings level from OY1 to OYF the full employment level.
  • Diagram (2) represents that as the price level drops from P2 to P1 with decline in money remuneration, earnings enhances from OY1 to the full employment level OYF through the enhancement in total demand via the Pigou effect.
  • This is represented in the downward inclining total demand curve AD.

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