Classical and Keynesian View on Wages and Employment


The classical economists held the view that the economic system automatically adjusted itself at the level of full employment through wage price flexibility. According to this view, there was a strong tendency towards full employment via wage adjustment. For example, if during depression, money wages were reduced all sound, it would be possible not only to reduce unemployment but eventually to create a situation of full employment.

A cut in money wages will lower marginal production costs and as a result, lead to increase output and employment. The output (and hence employment) will increase because reduction in production costs will enable the producers to lower prices and stimulate demand. Unemployment, if any will be temporary phase.

It will appear that the classical remedy for unemployment is to cut down the money wages all round. The process of bidding down the wages should continue till the employers find it worth while to employ all people seeking jobs. According to this view unemployment exists because wages are kept at a higher level than that some employers consider worthwhile. So long as there is some involuntary unemployment, wages and prices must continue to fall. This will lead to increase in investment output and income, until unemployment is eliminated.


We shall now briefly summarise the Keynesian view on wages and employment as under.

(i) In the first place, Keynes agreed with the classical economists that other things being equal, employment varied inversely with the level of real wages. That is, when real wages rose, the volume of employment was curtailed, and vice versa. In other words, the demand for labour depends on the real wage rates. It increases when the real wages rate falls and decreases when the real wages go up.

(ii) Keynes did not agree that a cut in money wages for the economy as a whole will necessarily cut the real wages. On the other hand, a reduction in the money wages reduced proportionately the total out lay, demand and prices so that the real wages remained the same unless real wages are reduced, employment can not increase. There is no doubt that an individual firm can, by cutting money wages, reduce costs and thus increase sales and employment. But when a general wage cut is affected through the economy, demand schedule will register a fall throughout, because all workers find their purchasing power reduced.

(iii) Keynes believed that while keeping the money wages constant, aggregate demand must be raised to increase employment. He said that it was possible to keep the money wages stable under a system of collective bargaining and the aggregate demand can be raised by fiscal and monetary measure.

(iv) Keynes further believed that a rise in aggregate demand, while the money wages are kept constant, would normally lead to a reduction in real wages. And a reduction in real wages would stimulate investment and increase employment. He agreed that since organisation, equipment and technique do not change in the short run; an increase in aggregate demand would result in increased output and a rise in marginal cost and prices. Rise in prices would mean a cut in real wages. It is increase in employment which reduces real wages and not the other way round.

(v) According to Keynes wage-earners do not mind a small rise in prices and do not agitate for a corresponding rise in money wages. But they vigorously resist a cut in money wages. Hence a better and more practical method of increasing employment is to raise aggregate demand and not cut money wages. For instance, the wages earners are offended at a cut in money wages but they can not blame the employer for a reduction in real wages. A cut in money wages also increase the burden of their debt. The wage earners are not satisfied even if the prices fall in proportion to the cut in money wages, because they fear that the prices may again rise to their old level. Thus according to Keynes, it is neither wise nor feasible to cut money wages the wage earners oppose cut in money wages even when the prices are falling. Thus, in modern times of strong trade unions it is impossible to cut money wages.

(vi) In order to explain why a general cut in money wages would not increase employment, Keynes analyses the effect of cut in money wages on the main determinants of income and employment viz marginal efficiency of capital consumption function and the rate of interest. He shows that all these factors are adversely affected by cut in money wages. Hence we can not hope to increase employment by cutting money wages, unless other factors are favourable.

Keynes comes to the conclusion that a cut in money wages neither remedy for unemployment nor a suitable prescription for increasing employment.

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