Pigou Effect

Pigou! Bless you.

The Pigou effect in economics describes the theoretical cause-and-effect relationship between deflation and other factors, like wealth and consumption. Let’s take a look at what Pigou was pigging on about.

During deflationary times...rare times, indeed...the poor man is suddenly rich! Well, richer. Deflation means prices go down, which makes your hard-earned dollars worth more than they were before. That’s kind of the same thing as if your income went up, like if you got a raise. And what would you do when you get a raise? No, you’re not going to be a responsible person and put it all in your retirement accounts. Arthur Pigou believed you’d spend...at least a bit more than before.

So deflation means increased wealth, and therefore increased consumption. What about employment?

The same logic applies: employers have more dollars to spend, too, which means more workers to buy. And they’ll be needing to hire more workers, because increased consumption means increased demand for stuff. Supply’s gotta meet that market demand somehow.

This whole thought process is pretty anti-Keynesian, since Keynes thought the Fed should do something during deflationary times. Arthur Pigou said we can chill during deflationary periods, since the market will self-correct: prices go down, wealth goes up, spending goes up, employment goes up, naturally.

There are anecdotes for and against the Pigou effect, but a funny one happened in Japan. It was thought that people weren’t spending more when prices fell in the 1990s because, like short-term traders, they thought prices would keep falling. Why buy now when you can buy later, if prices are continuing to fall?