How An Underrated Economic Thought Has A Potential To Reshape The World
By: Students Of Economics
Tags: Macroeconomics, International Relations, Economic Development

By Tayyab Rather

It has been almost a century since young economists have been polished and groomed to study the modern schools of economic thought whether it is Keynesian or Monetarist. Individuals are confined to have a thought process and are bound unconsciously to construct macroeconomic policies within these boundaries otherwise things could take a bad turn and nations would be doomed to failure. There have been very prominent examples like the Venezuela Crisis and Zimbabwe’s hyperinflation.

Even though there have been multiple economic failures in history, economists still tend to believe in different hypothesis yet these theories may not be as much effective compared to another part of the globe. This is because peoples’ sentiments, culture and social norms reflect upon the economy and hence different result of the same macroeconomic policy is observed.

Arthur Pigou

It is at such times during the 1950s, an English economist Arthur Pigou rose to the occasion and proposed his theory called the Pigou Effect. He was a supporter of the classical school and had cold clashes with Keynes. In fact, Keynes has mentioned him 17 times in his book “The General Theory of Employment, Interest and Money” of economics although his economic policies were researched for almost 3 decades by different schools including the Monetarist. Regardless of the criticism, he had faced, he was known as the “Master of Cambridge” for the management of the economic school in Cambridge University.

Pigou has faced a lot of criticism for distinctively supporting the process of deflation contradicting the maximum majority of economist.

Pigou stated that deflation in the economy would cause the Real GDP to increase. His statements were felt bizarre to the majority economists but his theory had sufficient evidence to prove so.

The Pigou effect could be explained in the following steps

Deflation would enable the prices of goods and services to be cheaper People would be able to consume more with lesser prices This would enable people to save more Savings would increase the investment Increased investment will contribute to the output, therefore, the real GDP shall increase

This theory was technically explained by Pigou using the IS-LM curve. This curve proves that the interest rate will remain the same although the output will be increased

When the saving increase, the investment also increases. This would shift the IS curve rightwards hence the interest rate shall increase.

Pigou defines wealth as the money supply divided by the price level for an individual. This would mean that deflation would cause increase savings and increased money supply providing increased wealth.

Wealth = Money Supplied / Price Level

The increase in money supplied would shift the LM curve rightwards also. This will decrease the interest rate bringing it back to its initial level and providing an increased Real GDP.

Drawbacks

Pigou’s theory has faced a lot of backlash especially concerning in the field of behavioural economics as well as its inability to work in a practical life situation which happened to occur in Japan.

Generally, during a period of deflation, consumers are hypothetically supposed to be spending the same as they did before, but due to the human psychology, Individuals start consuming even lesser than they did before in the hope that the prices would fall even further. This causes the LM curve to shift rightward although the IS curve stays the same thus, Interest rates decrease and output remains the same.

Japan’s Practical Example

In terms of a practical example, The ‘Pigou Effect’ has failed due to the process of behavioural economics as mentioned above. But this merely isn’t the only reason. Japanese people have an innate character in terms of saving and decreased consumption.

Japan now has a negative interest rate of -0.10% yet it’s households still do not invest in the economy. This concludes that Japanese Households save money in their accounts even after the periodical decrease in their wealth from doing so.

Conclusion and Opinions

Although the one time that the Pigou effect has failed to provide the necessary results, Many developing and third world countries can adopt this strategy but with controlled public sentiments by providing a transparent public guide about the general price levels and their overall general potential to decrease. This can give the general public a push start to know the exact opportunity to invest in the economy rather than keep on saving.

For the majority of the countries, a time like the coronavirus global pandemic might be the most suitable opportunity considering the increase in the unemployment levels and the levels of deflation.