Pigou Effect on Wage Cut and Full Employment (With Limitations)

Let us make an in-depth study of the Pigou effect on wage cut and full employment with its limitations.

Pigou Effect on Wage Flexibility and Full Employment:

Keynes argument that the liquidity trap would prevent wage price flexibility from restoring full employment has not gone unchallenged.

The distinguished economist A C. Pigou argued that even though the liquidity trap might bar the way to an increase in employment—via changes in interest rates and investment—falling wages and prices would sooner or later restore full employment because a decline in the price level would cause the consumption function to shift up.

The mechanism by which consumption rises is commonly called ‘Pigou Effect’. The essence of ‘Pigou Effect’ is that an overall reduction leads to increased spending on goods and services.

Pigou effect is based on the following assumptions:

(i) That individuals hold money, balances and spend them according to a desired ratio between these and their incomes,

(ii) Fall in prices increases the real value of money holdings which can now buy more goods,

(iii) The ratio between real balances and expenditures is disturbed because individuals have an excess supply of liquid assets, and

(iv) They spend a part of this excess supply on goods and services.

We can now easily understand why Pigou effect operates in the commodities market only.  Prof. A C. Pigou introduced an additional variable into the classical saving function, namely “the real value of cash balance.” Thus, Pigou’s neo-classical saving function should be written as: S = F(r, Y, m/p), where r is the rate of interest, Y the level of income, M represents the quantity of money in circulation (consisting of government-issued currency and government securities owned by consumers); P stands for the average price level or the cost of living index, so that M/P represents the “real value of cash balances.”

According to Prof. Pigou, there is a direct relation between the real value of liquid assets and the propensity to consume. His contention is that a fall in wages and prices will raise the “real value of cash balances” and other forms of accumulated savings (mainly government securities). This will, in turn, lead to an increase in the propensity to consume, thereby expanding investment and employment.

Just as people spend more on consumption with a rise in the value of their liquid assets, so they consume more if value of their liquid assets is increased as a result of a fall in the price level. As the level of prices falls, the real value of assets whose prices are fixed in nominal terms rises. A fall in the price level makes debtors worse off and creditors better off.

The magnitude of Pigou Effect is determined by the difference between the spending propensities of debtors and creditors in response to a change in the price level. The difference in the consumption responses to wealth changes is due to the fact that the government is a net creditor. If, then, it is assumed that the marginal propensity of the government to spend wealth is zero while the marginal propensity of the people to consume wealth is positive, a transfer of wealth from one section to the others due to a change in the price level will cause the level of total spending to change.

Thus Professor Pigou’s argument is that a fall in wages and prices may lead to a rise in the real value of money assets affecting propensity to consume favorably. This contention is based on the assumption that as the real value of cash balances increases, the desire to save out of real income is lowered.

Limitations of Pigou Effect:

To the extent the Pigou effect can raise the income level, it may be said that Pigou met Keynes on the latter’s own ground. At least in terms of pure theory Pigou seems to have ‘triumphed’ over Keynes in establishing the possibility of full employment through wage cuts. But economists, in general, concede no such victory to Pigou and classical theory.

Pigou Effect has been criticised on the following grounds:

1. Altogether Uncertain and Neglects Expectations:

Prof. K.K. Kurihara contends that falling wages and prices instead of increasing the propensity to consume may increase propensity to save. With wages and prices declining unchecked consumer’s overall asset position can be so adversely affected as to strengthen their desire to add more to their assets and less to their consumption, especially when the real value of consumer durables and such non-monetary assets is reduced much more than that of liquid assets is increased. The individuals who save seem to be rather rare birds, just the kind of people whose appetite for saving would grow as their stockpile of liquid assets is increased. Pigou Effect assumes too much about our knowledge of how an increase in the real value of money assets affects the propensity to save.

2. Very Weak:

Prof. Patinkin has stressed that “the stimulating effect of larger real cash balances on consumption may well be offset by the discouraging effect of increased debt burden (in real terms) has on consumption due to lower prices to leave the net effect very small, if any.”

3. Depends upon the Distribution of Assets:

Pigou Effect must be weighed quantitatively. It will depend upon the actual distribution of assets among different income groups and the extent to which the consumption function responds to an increase in the real value of liquid assets. The point to be remembered is that unless the lower income groups, the high consumers, own large money wealth (governments securities, etc.), Pigou Effect will have little importance: the scope for the operation of Pigou Effect is really small if assets are “continued to be owned by wealthy individuals and financial institutions rather than by broader consuming public.”

Even if the Pigou Effect could prove quantitatively significant, automatic full employment might not be the necessary outcome of wage-price flexibility. This is exactly the position in under developed countries having poor money and bill market. People do not have assets preference and do not possess securities, assets, or bills, so that when prices fall Pigou Effect is almost nil in such economies.

4. Operates only During Deflation:

Taking into consideration the short-term cyclical effects let us assume that the reduction in wage cost has been completed. What is the guarantee that the larger real value of money assets raises the consumption function, so that full employment is ensured? The reply is in the negative since as recovery progresses, prices will begin to rise and the real value of money assets progressively falls. Instead of acting as a reinforcing factor, the real-asset effect begins to vanish once the lower turning point in the cycle is reached.

5. MPC is Less than Unity:

The Pigou Effect can never work to bring full employment in the economy. Referring to it Hansen writes: “On the basis of Keynesian theory, it is possible to argue that reliance for stimulating effects of general wage reductions on consumption alone is bound to be self-defeating, because the marginal propensity to consume is less than one. Thus, optimistic expectations on the part of businessmen induced by the general wage fall are inevitably disappointed, unless the wage cuts stimulate investment as well as consumption. Any increase of output induced by a fall in wages will fail to generate enough consumption to absorb the entire increment in national income (so long as MPC is less than one).”

Thus, non-possession of money assets and those who possess, their desire to possess still more, change of consumption in response to permanent wealth appreciation and presence of money illusion are factors limiting the effectiveness of Pigou Effect. All things considered, the Pigovian argument appears impractical as an approach to the solution of the unemployment problem. In fact, Professor Pigou himself did not really see it being used for this purpose. He described certain aspects of his argument as “academic exercises of some slight use for clarifying thought, but with very little chance of ever being used on the chequer board of actual life.”