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.