Why Pigou's Hypothesis Prevents The Liquidity Trap
An economy in a liquidity trap cannot use monetary stimulus to increase output because there is little connection between personal income and money demand, John Hicks thought that this might be another reason (along with sticky prices) for persistently high unemployment. However, the Pigou effect creates a mechanism for the economy to escape the trap:
- As unemployment rises,
- the price level drops,
- which raises real balances,
- and thus consumption rises,
- which creates a different set of IS-curves on the IS-LM diagram, intersecting the LM curves above the low interest rate threshold of the liquidity trap.
- Finally, the economy moves to the new equilibrium, at full employment.
Pigou concluded that an equilibrium with employment below the full employment rate (the classical natural rate) could only occur if prices and wages were sticky.
Read more about this topic: Pigou Effect
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