Pigou's Wealth Effect Suggests That When the Price Level Falls

question 43

Essay

Pigou's wealth effect suggests that when the price level falls, consumers feel wealthier and so increase their spending.Another implication of falling prices, however, is that the real value of dollar-denominated debts will increase.For example, if you owe $100, the real value of your debt goes up, and you are worse off.If someone owes you $100, then falling prices make you better off.Now suppose that on average those who borrow money tend to spend a larger fraction of their income than do those who lend money.Will spending rise or fall as a result of a fall in the price level?

---

Definitions:

Marginal Product

Increment in production resulting from one extra unit of labor or capital.

Production Process

The method or sequence of operations involved in the conversion of inputs (like raw materials and labor) into finished goods or services.

Marginal Product of Labor

The additional output produced as a result of adding one more unit of labor, holding all other inputs constant.

Marginal Cost

The cost of producing one additional unit of a product.