Pigou effect

Definition

Economics concept that a large fall in prices would stimulate an economy and create the 'wealth effect' that will generate full employment. That is, as prices fall, more money becomes available to consumers for spending whose purchases create demand for more production and hence more jobs. This mechanism, however, does not work out in practice. Because, if a fall in prices is steep enough, many firms will go under carrying some banks with them because they would not be able to pay their debts. If the fall is gradual, no body would know where it will stop and both consumers and producers will hold on to their cash, thus creating a liquidity trap. Proposed by the UK's classical economist Arthur Cecil Pigou (1877-1959) who called it 'real balance effect.'