Mainstream economic theory holds that monetary policy effects the economy by influencing interest rates and hence investment. What did A.C. Pigou contribute to the analysis of the effects of monetary policy?

Mainstream economic theory states that monetary policy influences the economy by affecting interest rates and investment levels. Central banks implement monetary policy by adjusting the money supply, which in turn influences interest rates. Lower interest rates make borrowing and investing more appealing, leading to increased investment and economic growth. Conversely, higher interest rates deter borrowing and investing, slowing down economic growth. This theory assumes that a change in interest rates has a direct impact on investment decisions, thereby affecting overall economic activity.

A.C. Pigou, a British economist, made significant contributions to the understanding of monetary policy through his work on the Pigou effect, wage rigidity, and real balance effect. These concepts helped in comprehending the relationship between monetary policy, interest rates, and investment, and bridged some gaps in the mainstream economic theory.

The Pigou Effect is the phenomenon where a change in real money balances (the amount of money held by individuals) affects the overall consumption levels in the economy. When there's deflation (falling prices), people's real money balance increases, leading them to consume more, and vice versa for inflation. This change in consumption patterns affects the overall economy and investment decisions. This concept highlighted the importance of considering the effect of price levels on investment decisions and the overall economy while analyzing monetary policy.

Pigou also contributed to the understanding of why wages might be inflexible downwards (wage rigidity). He theorized that workers are less likely to accept wage cuts, even during an economic downturn, because they compare their wages to those of other workers. This wage rigidity could lead to higher unemployment levels during a recession, as employers might not be able to reduce wages to maintain employment. This insight is important for monetary policy analysis, as wage rigidity affects the relationship between interest rates, investment, and employment levels.

Pigou's insights about the real balance effect referred to how an increase in the real value of money (due to deflation, for example) would encourage people to consume more and save less, thereby increasing investments and economic activity. Furthermore, the real balance effect suggests that, in the long run, monetary policy can stimulate economic activity even if interest rates are at their lowest possible level (the liquidity trap). This concept illustrated that monetary policy could be effective even when conventional mechanisms, such as interest rate changes, are not working efficiently. In conclusion, A.C. Pigou's contributions to the analysis of monetary policy's effects provided valuable insights into price level changes, wage rigidity, and the real balance effect. These concepts helped refine the understanding of the relationship between monetary policy, interest rates, and investment decisions, providing a more nuanced view than the mainstream economic perspective.