Let us make an in-depth study of Keynes effect on wage flexibility and its limitations.

Keynes Effect on Wage Reduction:

It is maintained that a general wage cut will have the effect of reducing the wage bill, thereby leading to some reduction in prices and money incomes also.

It will decrease the demand for cash for transactions and business purposes.

In other words, lower wages and prices would lead to a reduction in the “transaction demand” for money thereby increasing the amount of money available for speculative purposes (assuming the quantity of money in circulation to be constant) lowering proportionately the “liquidity preference” for the community as a whole; in other words, the community will move down the pure liquidity preference schedule.


The lowering of the liquidity preference schedule will lower the rate of interest, and given the MEC, will encourage investment increasing income and employment. The greater the fall in wages and prices, the greater the quantity of money released from active balances to inactive (speculative) balances and therefore the greater the fall in the rate of interest.

This effect of lower interest rate via wage-reduction is called “Keynes Effect Proper”.

From the description of Keynes effect given above we can easily realise that it is based on the following line of reasoning :

(i) Individuals establish a desired relationship between the money balances that they hold and their expenditures on goods and services,


(ii) Price reductions raise the real value of their money holdings,

(iii) Thus, the desired relationship between real balances and expenditures is disturbed, and individuals come to possess an excess supply of liquid assets,

(iv) Individuals wish and are willing to lend part of this excess supply,

(v) An increase in the supply of funds in the loan market lowers the rate of interest,


(vi) With a lower rate of interest more investments take place.

The Keynes’ effect operates only in the bonds market. As such it differs from the Pigou effect which operates only in commodities market and from the real balance effect, which operates in both the markets for bonds and for commodities.

Limitations of Keynes’ Effect on Wage Reduction:

1. The Liquidity Trap:

It is argued that if the rate of interest has already begun nearing the level at which the schedule of liquidity preference becomes perfectly elastic, the fall in wages will have little or no effect on the interest rate. The cash released from transaction motive would be hoarded instead of being invested in securities.

2. Interest not Reducible Institutionally:

Further, wage reduction may fail to reduce the rate of interest to desired levels along a given MEC on account of the “administrative costs” of borrowing and lending. Administrative costs include the costs of management of debt, inconvenience, risk of altering the composition of different types of securities.

3. MEC May Fall Faster:

The marginal efficiency schedule may also shift downward to such a low position that interest rates cannot be reduced enough or to that extent. It is just possible that MEC (which is taken as given) may fall so low that only negative rates of interest will suffice to stimulate investment.

4. Other Factors Affecting MEC may not Favour:

Even if it is conceded that the rate of interest is lowered via wage reductions, it is doubled if investment would be stimulated, for, it has been asserted that the MEC schedule is inelastic with respect to changes in interest rate. Investment, it has been asserted in recent times, is not only a function of the rate of interest (as emphasized by classicals) but depends upon MEC which further depends upon a large number of business and psychological factors.

5. Equivalent to a Small Increase in Money Supply:

Lastly, Keynes took a more comprehensive view of the effects of wage reductions on employment. He did not confine his analysis to lowering of interest rate via wage reduction (called Keynes Effect). He himself stated that, used in this way, wage rate in effect becomes an instrument of money policy. He felt that the same results could be achieved by appropriate monetary policy, that is, by increasing the money supply.