Q.Explain the wage cut policy of Pigou.
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Start your 14-day free trial to unlock the full solution →The classical economist Pigou held that unemployment is caused by money wages being too high; by cutting money wages, cost of production falls, employment expands and full employment returns. Keynes rejected this, arguing that a general wage cut lowers incomes, purchasing power and aggregate demand, which reduces output and employment rather than raising it.
The classical (Pigou's) view
The classical economists, led by A. C. Pigou, believed that the economy automatically tends towards full employment and that involuntary unemployment exists only because money wages are kept too high (for example by trade unions or by a rigid wage structure).
Pigou's remedy — the wage-cut policy — runs as follows:
- If, during a depression, money wages are reduced, the cost of production falls.
- Lower cost makes it profitable for employers to produce more and to employ more workers.
- As each firm hires more labour, unemployment disappears and full employment is restored.
- Pigou also argued (the 'Pigou effect') that falling wages and prices raise the real value of people's money balances, which encourages more spending and employment.
In short, to the classicists a flexible, downward wage adjustment was the self-correcting mechanism that cured unemployment.
Keynes's criticism
J. M. Keynes strongly opposed the wage-cut policy on the following grounds:
- What is true of one firm is not true of the whole economy. A single firm cutting wages may employ more workers, but if all firms cut wages, total income and purchasing power fall.
- A fall in wages reduces the aggregate demand for goods, because wages are the main source of consumption spending. Lower demand means lower sales, so employers produce less and employ fewer, not more, workers.
- Thus a general wage cut deepens the depression instead of curing it. …
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