Keynes further asserts that the classical wage cut solution is unsatisfactory both in theory as well as practice. In modern times trade unions and political parties have been strongly supporting the cause of the working class. Therefore even if wage cut may make good economic sense, it makes bad political sense. But Keynes at once proves that it makes bad economic sense as well. In order that the wage cut solution should be effective, not only is a cut in the rate of monetary wages required; it is necessary that real wage rates should also fall. This is in view of the fact that levels of output and employment are real variables and therefore these can be altered only when the real cost of production goes down. Hence a fall in the rate of monetary wages must be accompanied by constant general level of prices (CPI). But this scarcely becomes possible because economic actions are strongly interdependent. Falling rates of monetary wages are invariably accompanied by a falling price level. In that case real rates of wages will be unaltered. Thus Keynes has found faults with the classical analysis in every respect. He then proceeds to present his own theory of employment.
(C) Effective Demand: The prospects of high levels of output and employment depend upon size of the effective demand and not the rate of wages. Effective demand is the total monetary expenditure of the community and is therefore a price. It depends upon two other variables, namely, aggregate demand (ADP) and aggregate supply price (ASP). Effective demand (ED) is then an equilibrium value determined at the point of intersection of the ADP and ASP schedules. These have been defined by Keynes as follows:
'ADP is that money value of all goods and services which producers actually receive.'
ASP is that money value of all goods and services which producers expect to realize in the market.’
Thus producers plan their output and employment decisions on the basis of value of the ASP that they expect. But in reality what falls in their hand is the total expenditure or ADP that consumers are prepared to undertake. If ADP value satisfies ASP value then the producers continue to produce as before and employ as many workers as before. But if ADP falls short of the ASP then producers’ expectations are not fully satisfied and they are induced to reduce output and demand for labor. This causes unemployment. Therefore the cause of unemployment has been detected. It is then deficiency in the effective demand that is the culprit which results in unemployment. Let’s illustrate this with the help of a figure. It will also help to draw a distinction between classical partial equilibrium and Keynes’ general equilibrium analysis.
1 Classical Theory
5. 2 Keynes'
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