real balance effect

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real balance effect

or

Pigou effect

the mechanism by which a change in the real value of money balances leads to a change in AGGREGATE DEMAND. If prices are flexible in an economy, a decrease in prices, for example, will increase the real value of a household's cash holdings. The increase in a household's money wealth increases its PURCHASING POWER, thereby stimulating consumption. By contrast, a rise in prices will decrease the real value of a household's cash holdings and by reducing its purchasing power cause it to consume less. Since prices are most likely to fall during a recession, then the Pigou effect will serve partially to offset the fall in consumption associated with the recession. However, if the Pigou mechanism occurred at a point of full employment, then the increase in consumer demand associated with the increase in real money wealth could not be satisfied because the economy would already be operating at full capacity. Here, prices would rise until real money balances were restored to their original level.
References in periodicals archive ?
Using an expanded IS-LM framework to include the Pigou effect, Kyer and Maggs (1992) also derived an expression for the price level elasticity of aggregate demand.
For example, and with respect to the real balance effect, also called the real wealth effect, the money wealth effect, and the Pigou effect, aggregate demand will be more elastic for any given change in the price level the more responsive is consumption spending to the resulting change in real wealth, ceteris paribus.
As a result, the Fisher effect dominates the Pigou effect, so that falling prices lead to lower, not higher spending, and if anything, this line of argument contributes toward the demand curve being positively, not negatively, sloped.
In the latter case some might invoke the Pigou effect (Grandmont's discussion 1983, pp.
242-44; 403-04; 498-503; and "The Pigou Effect Once More" {1952}, in Koo ed.
To take one example, if, given a change in prices, there can be a change in excess real balances and/or a change in liquidity preference, then what happens in the real world is a function of the relative weight of the two tendencies, an empirical matter with actual results varying over time, and with interactions; one need not focus exclusively on an all-powerful Pigou effect or Keynes effect.
10) More specifically, our theory is that inflation indexed bonds, as a component of wealth and via the Pigou effect, cause aggregate demand to become more inelastic with respect to the general price level.
It may happen in some circumstances but experience with deflation suggests that the stories told to generations of undergraduates about the Pigou effect are just 'too fantastic for words'.
First, Hayes disposes of the Pigou effect, brutally and succinctly, on the grounds that it applies only in a world with no debt and no bank money (pp.
However, it must be pointed out that the Pigou Effect was not articulated until 1946.
These are (1) the Pigou effect, whereby a rise in prices causes a decrease in real wealth, (2) the Keynes effect, where a rise in the price level decreases real money balances, causing a rise in real interest rates which, in turn leads to a fall in durable consumption and investment purchases, (3) the international price level effect, where a rise in prices decreases the international competitiveness of domestic goods, and (4) the intertemporal price effect, where higher prices cause people (consumers, businesses, and financial institutions) to substitute from consumption now to future consumption.
It is well-established in macroeconomic theory that, for a closed economy analyzed with the neoclassical IS-LM framework where normal conditions prevail in both the commodity and money markets, the Pigou effect reinforces the Keynes effect and causes the aggregate demand curve to be more elastic with respect to the general price level.