Chapter 6 complete

6.6.1 The Pigou Effect
The Pigou effect is also known as wealth effect, was propounded by Arthur C. Pigou in 1943 
to counter Keynes’ argument that wage-price deflation cannot leads to automatic full 
employment. We will use here IS and LM model to understand the Pigou effect. The IS curve 
shows equilibrium between the interest rate and the national income goods and services 
market while the LM curve shows an equilibrium between rate of interest and national 
income in money market. For any given supply of money (M), a lower price level implies 
higher real money balances (M/P) or for given price level, when supply of money increases; 
real balances of people increases (M/P). An increase in real money balances causes an 
expansionary shift in the LM curve, which leads to higher income. This is illustrated in the 
Figure 6.3. The real money balances (M/P) is shown along the vertical axis and income or 
output (Y) is shown along the horizontal axis in the Figure 6.3. The increase in real money 
balances means increase in purchasing power of money or decrease in price of commodity. 
Figure 6.3 shows that a decrease in price from Rs.15 to Rs.10 increases real money balances. 
An increase in real money balances causes an expansionary shift in the LM curve, so that 
initial LM curve shifted to LM1curve and it intersects IS curve at point E1 at higher level of 
income, Y1 as sown in the Figure 6.3. 
Another channel through which falling prices expand income is called the Pigou