Pigou Effect and Employment –
Cut in wages and consequent fall in prices produces a favourable effect on the aggregate demand and employment in another way which was first pointed out by Pigou, that’s why it is known as Pigou effect. This is also called Real Balance Effect.
According to Pigou Effect, when wage cuts are made it causes a fall in prices, which in turn increases the real value of money balances, which makes people rich or we can say increases their purchasing power and increased purchasing power induces them to increase their consumption expenditure and raises aggregate demand and employment in times of depression.
Keynes and his followers admitted that the real balance effect operated but they also expressed doubts about its quantitative significance. Although the real balance effect is theoretically possible but empirical evidence shows that it is not strong enough to raise aggregate demand sufficiently to ensure full employment.
Pigou effect has been subsequently developed by Don Patinkin under the title of real balance effect. Don Patinkin tried to show that Keynes was wrong for advancing the view that the free market economy did not have a mechanism to restore full employment equilibrium after an initial disturbance.
According to Patinkin, the real balance effect will bring the economy back automatically to full employment.
There may be some increase in output and employment as a result of the working of the real balance effect. But the important question is that whether it is quantitatively strong enough to get the economy out of depression and restore full employment.
The real balance effect is not significant to ensure the full employment.
According to Steward, ‘The prices of falling prices was limited in its extent, it was not possible for the expansionary effect of its purchasing power to be more than a minor effect to the contractionary effect of falling incomes, consumption and investment, particularly when account was taken of the multiplier.