Correcting a Favorite Textbook Author
A fall in wages
increases the incentive to hire (call this the substitution effect) but it
decreases the income of people who already have jobs and this in turn
decreases their spending and other people’s income (call this the macro income effect).
Yes, assuming their hours are fixed, wage cuts decrease the income of people who already have jobs. But it is premature to claim there is a negative macro income effect, because there are two countervailing factors. Cutting wages can easily increase overall income and spending because…
1. Lower wages do not imply lower overall labor income. If labor demand is elastic, total labor income actually rises.
2. No matter how little or how much employment increases as a result of lower wages, a $1/hour fall in labor income still necessarily implies a $1/hour rise in employer income. Unless employers have a higher marginal propensity to stuff their income under mattresses than workers, overall income and spending stay the same or go up.