When price fall as a result of a cut in money wages, the purchasing power of money with a consumer increases or there is increase in real value of money balances. People feel that they are now better off and they increase their consumption expenditure. This leads to economic expansion or increase in GNP. The way in which an increase in the real value of money balances results in the expansion of economic activity has been described as the “Pigou Effect” it is also called real balances effect.
Pigou Effect was of the opinion that shifting of consumption function upward was due to increase in the real value of money assets resulting from a fall in money wages and prices. This is the real balance effect.
When wages and prices fall the total real value of public’s holding of wealth which has fixed money value will increase though wealth in form of goods land or equities will depreciate. Thus a fall in prices will increase in real terms the wealth of consumers to the extent that its money value is fixed. Now consumption function is an increasing function of the level of wealth and income. Hence a rising real value of wealth stimulates consumption out lays at all levels of income. Thus we see that Pigou concentrates exclusively on the real value of money assets.
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