Pigou effect

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liquidity trap

John Maynard Keynes (1883—1946) economist

Arthur Cecil Pigou (1877—1959) economist


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The argument that a fall in prices increases real wealth (the real balance effect) and raises aggregate demand. The Pigou effect implies that if prices fell sufficiently in a slump, full employment would be restored because of the resulting real balance effect. There are several shortcomings with this argument. In an economy with money debts, large falls in prices would damage the solvency of many firms, and probably cause the collapse of some financial institutions. Perfectly flexible prices and wages might ensure real stability in the economy; if prices and wages fell gradually, however, the prospect of further falls to come would bring the liquidity trap into play, with adverse effects on real spending, so the short-term effects of greater price and wage flexibility might well make slumps worse.

Subjects: Economics.

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