Sunday, May 6, 2012

Are workers employed for nominal or real wages?

Continuing my reading of Lord John Maynard Keynes' The General Theory of Employment, Interest, and Money, Chapter 2, Section III, one find's Lord Keynes discussing whether workers are employed for a nominal or a real wage. The classical theory would postulate that workers put forth effort in order to receive a certain amount of purchasing power, which compensates for that effort. In other words, one would expect people to work for a real wage.

Logically, if workers are employed for a real and not a nominal wage, then what does that mean we should find in empirical reality? Keynes points out that there are a number of results:

(1) When deflation, a reduction of the price level, occurs, then a fixed nominal wage is actually a rising real wage. This would be seen as the same thing as a rising nominal wage with a fixed purchasing power. One would expect that, all else equal, the effort put forth would increase with a rising real wage.

(2) When inflation, an increase of the price level, occurs, then a fixed nominal wage is actually a falling real wage. This is the same as a declining nominal wage with a fixed purchasing power. Thus, one would expect that the effort put forth by workers would decrease with a reduced real wage.

The main point is that it is only the real wage that matters for employment, not the nominal wage. This is the issue of money illusion. If it is solely the real wage that matters, then money is a veil and workers can see right through it. If inflation or deflation occurs, it does not matter because the real wages will remain the same. If the nominal wage does matter, then we would expect that when inflation eats away at the value of a fixed nominal wage, workers would be less willing to put in the same effort for the same wage. Secondly, if deflation occurs, but nominal wages remain the same, it would increase the workers' willingness to put forth effort, since their wages have actually increased in real terms.

Lord Keynes sees great significance in the existence of money illusion and believes that it is confirmed by actual experience. Keynes says, "[I]t would be impractical to resist every reduction of real wages, due to a change in the purchasing power of all workers alike; and in fact reductions of real wages arising in this way are not, as a rule, resisted unless they proceed to an extreme degree." He adds, as partial justification, "Every trade union will put up some resistence to a cut in money-wages, however small. But ... no trade union would dream of striking on every occasion of a rise in the cost of living...".

In general, if a little inflation eats away at the real value of a wage, workers tend to acquiesce, perhaps partly because they do not expect the situation to be permanent, as their nominal wages  (and usually real wages) rise over time. But further, people are not as rational as that classical model would indicate. As Professor Paul Krugman occasionally points out, there is downward wage rigidity and it is very hard to get people to take a cut in nominal wages. Lord Keynes helped to bring economic science forward considerably, in this respect.

Update: Some of the issues in this post were touched upon recently in the post "The master teaches us about involuntary unemployment".

4 comments:

  1. Nice summary.

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  2. Thought the same thing, but then saw Anonymous said it first.
    At first it was thought that it was "money illusion", but with RE that progressed to "wages adjust immediately to changes in expectations about inflation". The NK thinking brought back the "rigidity argument" which seems more palatable.

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  3. Yep, I'm stuck in a fixed nominal wage, declining real wage..... I certainly "get" the concept!

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  4. @João Marcus,
    I find myself very interested in the Calvo model of price adjustments. When I imagine a modification to it, I tend to think that it would only make sense if the timing/speed of price adjustments are likely influenced by the expected rate of inflation. Are you aware of any research along these lines?

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