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Thursday 3 January 2013

Did Ricardian Equivalence kill the Pigou effect?

For macroeconomists

After the last time the world got into a liquidity trap, there was a debate about whether price flexibility would be sufficient to get us out of the trap. That debate tended to assume a fixed money supply. With that assumption, the answer today would be yes, if falling prices raised inflation expectations (given long run neutrality) and therefore reduced real interest rates. Back then that story was not so popular, perhaps because the debate pre-dated rational expectations. Instead the argument at the time focused on the Pigou or Real Balance effect. Falling prices raised the value of outside money, so everyone would feel wealthier and spend more.

We do not hear this argument so much nowadays. I have not seen this discussed in the advanced textbooks I know well (for example neither term is in the index of Romer or Obstfeld and Rogoff), so I was wondering why that was. Is the Pigou effect not what it was once thought to be? I could not find a clear answer to this question anywhere, but of course that may be my failing. So here are my thoughts, but they come with the possibility that I have just missed something. If I have, I will rewrite the post accordingly.

What I did find were a few papers that appeared to suggest that Ricardian Equivalence (REq) killed the Pigou effect. Here is a quote from a paper by Peter Ireland. After talking about REq, he writes

“Less widely appreciated, however, is a closely related finding, presented most explicitly by Weil (1991) but also implicit in earlier work by Sachs (1983) and Cohen (1985). These authors show that government-issued fiat money will not be perceived as a source of private-sector wealth if the households owning that money are the same households that, first, receive all of the transfers or pay all of the taxes associated with future changes in the money supply and that, second, incur all of the opportunity costs associated with carrying the money stock between all future periods. We are used to the idea of Ricardian Equivalence implying that government debt is not net wealth. Essentially consumers internalise the government’s budget constraint. But that argument applies to outside money as much as government debt. We can replace initial values of debt and money by the discounted future stream of primary surpluses they support.”

The easiest way to describe REq is that the infinitely lived representative consumer consolidates the government’s intertemporal budget constraint (IBC) into its own. Suppose this consumer owns some nominal (non-indexed) government debt, and the price level falls. Is that consumer better off? The real value of the future interest they receive on that debt will be higher, but this will be offset by the higher taxes in real terms that the government will raise to pay for this. The same argument applies to the higher real redemption value of the debt.

Ireland argues that exactly the same points can be made about outside money. Suppose money pays no interest, but consumers hold it because of the liquidity services it provides.
But if the consumer already has all the liquidity services they need (as they do in a liquidity trap), a fall in prices that creates more of this asset in real terms does not make the consumer better off on this account. So what about the redemption value of the additional real balances?

Here I’m inclined to think that money is different from government debt. In a paper[1] that I do not think has been published, Willem Buiter argues that money is irredeemable. The government only promises to redeem money with itself. So if I get a tax cut that is financed by printing money rather than issuing debt, there is no offsetting future tax liability. For this reason, money – unlike government debt – is net wealth for the consolidated public and private sectors.

Now a standard response is to say that a money financed tax cut does not make the consumer better off because the price level will rise, reducing the purchasing power of that money. It seems to me that is a different argument to REq – it requires going beyond just thinking about budget constraints. It is also an argument that does not apply to the Pigou effect, which is what happens if prices fall, raising the value of real balances.

Does the irredeemable nature of money rescue the Pigou effect from the REq argument? Yes and no. There is a crucial difference between Buiter’s analysis and the traditional view. In Buiter, it is the present discounted value of the terminal stock of base money that is net wealth for the consolidated private and public sectors, rather than its current value. To see why this matters, consider the liquidity trap case again.

As we have already noted, there is no liquidity trap in the flexible price case when the government holds the nominal stock of money constant, because falling prices today imply higher expected inflation. We do not need a Pigou effect. But the more interesting case, which I have talked about before, is where the government or central bank has an inflation target. In this case the authorities prevent inflation expectations rising, so real interest rates do not fall.

In that case nominal money will not be held constant when prices fall. Instead, the authorities will contract the nominal money stock in line with falling prices, to make sure inflation does not rise. As a result, there will be no increase in consumption, because the terminal value of nominal money falls, and its real value stays constant. Or, to put the same point another way, higher future taxes required to reduce the money stock will offset the wealth impact of higher current real money balances. There is no Pigou effect.

This is all terribly stylised and unrealistic, so there is no need to add comments that just point this out. However, I hope I’m not the only one who thinks this thought experiment is 
interesting. I also think that the proposition that inflation targets prevent macroeconomic ‘self-correction’ even when prices are flexible has a symbolic importance.

[1] Buiter, W.H. (2003) Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap, NBER Working Paper No. 10163.


  1. You say that under inflation targeting "the authorities will contract the nominal money stock in line with falling prices, to make sure inflation does not rise".

    Would not the aim of an inflation targeting regime rather be to prevent falling prices by increasing the money supply when downward price-pressure is observed?

    This increased money supply would increase real cash-balances and make the current price level sustainable. This to my mind would be a "wealth affect".

    1. The way to think about this is an unanticipated negative shock that drives down prices before monetary policy can react. Now the thing about inflation targeting, as opposed to price level targeting, is that this is water under the bridge - the monetary authorities only care about future inflation. So they try an avoid prices rising again.

    2. Thanks for the clarification. Now I understand the post.

  2. It's some kind of price-flexibility which puts the world inside the liquidity trap. The beginning of the Great Recession, it's a Fisherian story, but not just any one, it's a debt-deflation story. Falling prices raised deflation expectations. Everyone would feel wealthier and spend less. Everybody panics and sells assets to stay liquid.

  3. Interesting post. Even on Pigou's terms, when prices fall and boost real balances, shouldn't this positive wealth effect be offset by falling nominal interest rates earned on these balances? Thanks

  4. Very Interesting post; I will give it further reflection once i have read Peter Ireland's paper.

  5. Buiter discussed this in his Hahn lecture in 2005 where the Pigou Effect was considered one of two monetary "ghosts":, see pages C9-10. Indeed, there is no Pigou effect as traditionally defined, but "With irredeemable government fiat money, base money is net wealth in the sense that the present discounted value of the terminal stock of money balances is
    part of the private sector’s comprehensive wealth after consolidation of the HIBC and GIBC. Thus, there exists a weak form of the real balance effect even in the representative agent model with rational expectations."

    Worth also recalling Tobin's Jahnsson Letures, published as "Asset Accumulation and Economic Activity" where he revisits the Pigou versus Keynes versus Fisher effects. Capsule summary: The stock of outside money is too small, so Pigou effect no big deal. Whereas inside money, and the relative financial position of debtors versus creditors that net out in the aggregate, would reveal relative position of debtors to deteriorate because of falling prices -- hence Irving Fisher's debt deflation theory. In other words, you need to break Buiter's representative agent assumption. This could cause the IS curve to change slope etc.

    1. Fascinating, thanks for the paper. You realize that even to somebody with a smattering of economic knowledge, like myself, your post reminds one of the differences between iconoclasts and their opponents in Byzantine medieval debates? Or even more obscure camps. That's the problem with economics: the tiniest perturbation changes everything, like for example the assumptions behind the REq (e.g. inter-temporal transfers)

  6. The Buiter paper mentioned is available (as are all of his papers) on his web-site here:

  7. Robert Barro (link: ) argued that due to Ricardian Equivalence in the presence of an operative bequest motive the public is not fooled into thinking they are richer when the government issues bonds to them, because government bond coupons must be paid from increased taxation. Therefore, he said that:
    1. At the microeconomic level, the subjective level of wealth would be lessened by a share of the debt taken on by the national government. 2. Bonds should not be considered as part of net wealth at the macroeconomic level. 3. Therefore: There is no way for the government to create a "Pigou effect" by issuing bonds, because the aggregate subjective level of wealth will not increase.

  8. Seems to me this is approaching MMT, if I understand this correctly.

    1. I elaborate on this point here:

  9. "Here I’m inclined to think that money is different from government debt. In a paper[1] that I do not think has been published, Willem Buiter argues that money is irredeemable. The government only promises to redeem money with itself. So if I get a tax cut that is financed by printing money rather than issuing debt, there is no offsetting future tax liability. For this reason, money – unlike government debt – is net wealth for the consolidated public and private sectors."

    This argument is wrong. Printing money debases the currency and inflation in this case is a hidden form of taxation (liability).

  10. Printing money does not necessarily debase the currency and cause inflation. It is necessary for economic growth for the money supply to increase. The key issue is to increase it at roughly the same rate as the productive capacity of the economy. If there is inflation you are increasing it too fast. If there is deflation and/or unused productive capacity you are increasing it too slowly. It is not rocket science.


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