Keynes’s Effect and Employment –
Keynes’s Effect says that the cut in money wages and consequent fall in prices is likely to reduce the rate of interest which will favourably affect the investment demand.
While Pigou Effect traces out the favourable effect of money wages cut on consumption demand through the increase in real value of money balances.
According to Keynes, when the cut in money wages is made and consequently prices fall and transactions demand for money will fall which will cause increase in the money supply for speculative motive and this will further cause a reduction in the rate of interest. At a lower rate of interest, there will be more investment which will raise the level of aggregate demand and employment.
This Keynesian analysis to increase the investment and employment totally depends on lowering the rate of interest by cutting money wages and consequently fall in prices.
Keynes also said that the rate of interest can be lowered by expanding money supply. According to Keynes, theoretically, ‘we can produce the same effect on the rate of interest by increasing the quantity of money while keeping the level of wages unchanged. ‘
According to him, expansionary monetary policy to reduce rate of interest is preferable to the policy of reducing mony wages which will be resisted by the workers and also an all around wage cut will reduce consumption demand for goods and will adversely affect employment.
Keynes emphasize that expansionary monetary policy will not necessarily ensure full employment and flexible wage policy have its effects on rate of interest are of concerned. To what extent increase in money supply will succeed in lowering rate of interest and boost investment demand depends first on interest elasticity of the liquidity preference curve and secondly on interest elasticity of investment demand curve. If the liquidity preference curve is highly elastic, the increase in quantity of money would not bring much fall in the rate of interest. And if the investment demand curve is relatively inelastic, then even the fall in the rate of interest as a consequence of expansion in money supply would not be able to achieve much increase in investment.
Keynes was not hopeful of securing adequate increase in employment by either flexible wage policy of flexible monetary policy at times of depression.