The pigou effect, also called the real balance effect, is named after the well known Cambridge school economist Arthur Cecil pigou who had first clearly formulated the relationship between the aggregate consumption, the real cash balances and the general, price level. This particular effect was advanced to counter the Keynesian argument that a fall in wages and prices exerts its influence only through the interest rate which becomes inflexible in the downward direction at the liquidity trap interest rate where the aggregate effective demand was less than was necessary to ensure full employment in the economy and to defend the classical position relating to the effect of the general wage cut in achieving full employment during the course of a serious controversy which ensued in the early forties between pigou and john Maynard Keynes, Keynes had strongly refuted the classical argument that a general wage cut could remove unemployment in the economy.
Keynes and his followers had demonstrated the failure of a perfectly competitive free market economy to achieve a stable equilibrium at full employment. The arguments of the Keynesians opened the floodgates of government intervention in individual economic articles. It was at this time that other economists, particularly Gottfried von Harbourer and A. C. pigou took position to challenge this conclusion suggesting that the Keynesians had ignored the importance of the real balance effect on individual's behaviour. Both pigou and Haberler arguments were based on the assumption of important role of wealth in the determination of the consumption function.
The pigou or the real balance effect measures, ceteris paribus, the influence of a change in individual wealth holder real balance on the aggregate effective demand. Pigou had argued that a general price fall which was associated with a general wage cut would, by increasing the real value of the cash balance of individual, raise the level of aggregate demand in the economy by shifting the aggregate consumption function upward. If in fact an increase in the real value of wealth stimulates consumption if could then be conceived that there would always be some fall in wages and prices which would be sufficient enough to increase the aggregate consumption sufficiently enough to eliminate any deficiency in the aggregate effective demand at full employment level in the economy. Pigou statement bears repetition here because different interpretations have been given to it. According to pigou.
As money wage rates fall money incomes must fall also and go on falling. Employment, and so real income, being maintained, this entails that prices fall and go on falling, which is another way of saying that the stock of money, as valued in terms of real income correspondingly rises. But the extent to which the representative man desires to make savings otherwise than for the sake of their future income yield depends in part on the size, in terms of real income, of his existing possessions, as this increases, the amount that he so desires to save out of any assigned real income diminishes and ultimately vanishes, so that we are back in the situation .......Where a negative rate of interest is impossible.