A Note on the Incompatibility of the Pigou Effect and a Liquidity Trap

Abstract

the Pigou effect. This paper shows that the presence of a liquidity trap would preclude the presence of a Pigou or real-balance effect in the commodity market. This implication is an important aspect of the liquidity trap which has been overlooked in almost all macro textbooks, as well as in some of the literature. More specifically, there is a confusion in textbooks which assert that a Pigou effect would rescue the economy from the horizontal liquidity trap developed by some texts. Rather, it is logically incompatible to talk about infinitely elastic demand-for-money curves and the Pigou effect. Hence, the Keynesians were correct in claiming that, if the economy were indeed stuck in a liquidity trap, then monetary policy (or falling prices which raised the real money supply) would not restore the economy to equilibrium; a Pigou effect could not come to the rescue.