Effects of Wage Cuts on Effective Demand

The following points highlight the three important effects of wage cuts on effective demand. The effects are: 1. Wages and Investment 2. Wages and Consumption 3. Wages and the Rate of Interest.

Effect of Wage Cuts # 1. Wages and Investment:

If a general wage cut is likely to be repeated in future the expectation of possibility of further wage reduction in future will have adverse effect on investment.

The entrepreneurs would continue to postpone investment in the expectation of a further fall in wage rate in future, unless wages have touched the rock-bottom.

This will not diminish efficiency of capital but will also lead to the postponement, both of investment and consumption.

If, however, the nature of wage cut is such that it is not expected to be followed by further cuts, it will have favourable effect on investment, as a cut in money wages reduces the cost of production and expands the profit margin.

The practice, however, of modern democratic economies seems to be that of a slowly falling wage level, rather than a once-for-all cut in wage levels which has quite adverse effect on MEC and investment. “A rigid money wage policy would probably have a more favourable effect on MEC than a policy in which wages sag slowly to lower and lower levels.”

Thus, it all depends upon the nature of the wage cut. It is argued that a general reduction in money wages may lead to favourable expectations in the minds of entrepreneurs and may increase the MEC and investment but labour reaction under such circumstances assumes special importance.

If workers decide to resist strongly any reduction in money wages and ask for higher wages in future, then these labour troubles may offset the otherwise favourable expectations on investment.

A cut in money wage rates will agitate labour more than “a gradual and automatic lowering of real wages as a result of rising prices.” Even though workers know that wage cuts would mean more jobs for them in general, in the absence of overall collective bargaining, self-interest would compel any group of labour to resist reductions in wages.

Wage cutting is likely to lead to a fall in the propensity to consume. The fall in consumption level would occur on account of the radical change in the distribution of income because wage cuts would mean that more income will go to low-consuming and high-saving group of businessmen, rentiers, and from high-consuming, low-saving group of wage-earners.

Hence, as a result of the redistribution of income, consumption would fall and saving would increase leading to a fall in effective demand. “Money wage rate changes are double-edged; they change money costs but they change at the same time money incomes and hence money expenditures.”

In particular cases it is perfectly correct to concentrate on analysis of the “effects of wage reductions” on costs, ignoring at the same time the effects of these cuts on demand. But while examining the effects of general wage cuts one cannot ignore the effects of wage reductions on demand as well as costs.

One thing, however, is clear that an upward shift of investment function accompanied by an upward shift of saving function inevitably leads to “underemployment equilibrium.” Since investment depends upon many factors besides cost and demand, the net result of wage changes on propensity to invest (investment) is indeterminate.

Further, with reduction in money wages and consequent fall in prices, the burden of public debt is increased and entrepreneurs find it very hard to meet obligations of paying to the debenture-holders the stipulated sums.

This also increases the real burden of the national debt, which necessitates higher taxation required to service and to repay public debt. Thus, any favourable effects on business expectations are offset by the depressing effects on investment of a greater burden of debt, both public and private.

Effect of Wage Cut # 2. Wages and Consumption:

The most important constituent of effective demand is consumption. Classicals held the view that wage-cuts affect consumption in a favourable manner. Their argument was that a fall in wage-rates will reduce the costs of production, which in turn will lower prices.

Lower prices will increase consumption on account of extension in demand. But this was a vain attempt to apply certain principles concerning the price and demand of a particular product to the problem of total consumption. Classicals emphasized wage as a cost of production and conveniently forgot that while wages were costs to producers, they were income to wage-earners.

According to Keynes, wage-cuts do not affect consumption favorably. Wage cuts will result in the redistribution of income favouring the rich; for example, when wages are lowered the incomes of the interest and rent-receivers remain the same or may even increase as compared to the incomes of wage-earners; thus, redistributing income in an unequal manner as it is shifted from groups having high consuming propensities (workers and the poor) to the groups having high saving propensities (the capitalists and the rich).

The consumption of wage-earners will fall, thereby leading to a decline in the total demand and hence in production and employment. Professor A C. Pigou, however, argued that when prices fall in the economy due to wage-cuts, the real value of money assets (bonds and securities) goes up.

This appreciation in real value of the money wealth of people is likely to induce them to consume more. This likely increase in consumption resulting from wage-cuts is called the Pigou Effect or the Real Value of Money Asset Effect. But there are writers who have expressed grave doubts about the practical significance of ‘Pigou Effect’ in a depression-ridden economy.

Effect of Wage Cuts# 3. Wages and the Rate of Interest:

Keynes considered the possibility that wage-cuts by lowering the rate of interest may stimulate investment and hence employment. It was contended that when wages are lowered people will have less demand for money for day-to-day transactions. A fall in wages will normally be accompanied by a fall in prices (because the purchasing power of the people will be reduced).

The lower wages accompanied by lower prices will lower the demand for the amount of money needed to carry on transactions (M₁). They shall, therefore, be left with some surplus cash which they are likely to use for speculative purposes (M₂) i.e. for the satisfaction of the desire to gain from the fluctuations of the rate of interest.

When the supply of money for speculative purposes will increase, it will also bring down the rate of interest. Assuming that total supply of money (M) remains constant, a fall in the transaction demand for money (M₁) will increase the money supply required to satisfy the speculative demand for money (M₂), which, in turn, will lower the rate of interest. The reduction of the rate of interest, in this way, is called the Keynes Effect. The extent to which the rate of interest will fall will depend on the quantity of money released from active balances (M₁) to inactive balances (M₂) and the interest- elasticity of liquidity preference for speculative balances.

But wage cutting is an extremely unwise way of reducing the rate of interest. The most suitable way to lower interest rate is to follow a monetary policy of increasing the supply of money. Having thus analysed the possible influence of wage cutting on effective demand.

Keynes concluded that a monetary policy is better way of achieving the same result than a wage policy. Considering the painful effects of wage cuts, he observed that “only a foolish person would prefer a flexible wage policy to a flexible money policy.”