Money Wages and Money Illusion

A couple of weeks ago, in the first of three posts about Armen Alchian’s discussion of the microeconomic underpinnings for Keynesian involuntary unemployment, I quoted the following passage from a footnote in Alchian’s classic paper, “Information Costs, Pricing, and Resource Unemployment.”

[C]onsider the following question: Why would a cut in money wages provoke a different response than if the price level rose relative to wages – when both would amount to the same change in relative prices, but differ only in the money price level? Almost everyone thought Keynes presumed a money wage illusion. However, an answer more respectful of Keynes is available. The price level rise conveys different information: Money wages everywhere have fallen relative to prices. On the other hand, a cut in one’s own wage money wage does not imply options elsewhere have fallen. A cut only in one’s present job is revealed. The money versus real wage distinction is not the relevant comparison; the wage in the present job versus the wage in all other jobs is the relevant comparison. This rationalizes Keynes’ definition of involuntary unemployment in terms of price-level changes. If wages were cut everywhere else, and if employees knew it, they would not choose unemployment – but they would if they believed wages were cut just in their current job. When one employer cuts wages, this does not signify cuts elsewhere. His employees rightly think wages are not reduced elsewhere. On the other hand, with a rise in the price level, employees have less reason to think their current real wages are lower than they are elsewhere. So they do not immediately refuse a lower real wage induced by a higher price level, whereas they would refuse an equal money wage cut in their present job. It is the revelation of information about prospects elsewhere that makes the difference.

Saturos made the following comment on that post:

“The price level rise conveys different information: Money wages everywhere have fallen relative to prices. On the other hand, a cut in one’s own wage money wage does not imply options elsewhere have fallen.”

But that is money illusion. If my money wage rises by less than inflation, that says nothing about whether other money wages have risen by less than inflation. There is no explanation for a separate behavioral response to a cut in one’s observed real wage through nominal wages or prices – unless workers are observing their nominal wages instead of their real wages, i.e. money illusion.

I gave only a cursory response to Saturos’s comment, though I did come back to it in the third of my series of posts on Alchian’s discussion of Keynesian unemployment. But my focus was primarily on Alchian’s discussion of the validity of the inflation-induced-wage-lag hypothesis, a hypothesis disputed by Alchian and attributed by him to Keynes. I discussed my own reservations about Alchian’s position on the wage lag in that post, but here I want to go back and discuss Saturos’s objection directly. My claim is that there is a difference between the assumption that workers observe only nominal, not real, wages, in the process of making decisions about whether to accept or reject wage offers and the assumption of money illusion.

Here is how to think about the difference. In any period, some workers are searching for employment, and presumably they (or at least some of them) can search more efficiently (i.e., collect more wage offers) while unemployed than employed.  In obtaining wage offers, workers can only observe a nominal wage offer for their services; they can’t observe a real wage, because it is too costly and time-consuming for any individual to collect observations for all the goods and services that enter into a reasonably comprehensive price index, and then compute a price level from those price observations. However, based on experience and other sources of information, workers, like other economic agents, form expectations about what prices they will observe (i.e., the prices that will clear markets). In any period, workers’ wage expectations are determined, in part, by their expectations of movements in the general price level. The higher the expected rate of inflation, the higher the expected wage. The absence of money illusion means that workers change their expectations of wage offers (given expectations about changes in real wages) in line with their expectations of inflation. However, within any period, workers’ expectations are fixed. (Actually, the period can be defined as the length of time during which expectations are held fixed.) This is simply the temporary-equilibrium construct introduced by Hicks in Value and Capital and again in Capital and Growth.

With expectations fixed during a given period, workers, observing wage offers, either accept or reject those offers by comparing a given nominal nominal wage offer with the nominal reservation wage settled upon at the beginning of the period, a reservation wage conditional on the expectation of inflation for that period formed at the beginning of the period. Thus, the distinction made by Alchian between the information conveyed by a nominal-wage cut at a constant price level versus the information conveyed by a constant money wage at an unexpectedly high price level is perfectly valid, and entails no money illusion. The only assumption is that, over some finite period of time, inflation or price-level expectations are held constant instead of being revised continuously and instantaneously. Another way of saying this is that the actual rate of inflation does not always equal the expected rate of inflation. But to repeat, there is no assumption of money illusion. I am pretty sure that I heard Earl Thompson explain this in his graduate macrotheory class at UCLA around 1972-73, but I had to work through the argument again for myself before remembering that I had heard it all from Earl about 40 years earlier.


6 Responses to “Money Wages and Money Illusion”

  1. 1 Ritwik June 28, 2012 at 4:17 am

    Yes, adaptive expectations instead of ratex and ‘sticky information’ as Mankiw called it, will do the job. No need of money illusion. This is the point made over and over again by Leijonhufvud, as I understand.


  2. 2 David C June 28, 2012 at 6:53 am

    I’m not sure how it applies to this discussion, but here’s an observation that I made many times as a hiring manager in the Midwest.

    We hired scientists with advanced degrees, in a job market that was certainly national in scope. As an employer in Michigan, it was quite common to hear applicants tell us that they had accepted positions in New Jersey because “the salary offer was higher.” This was true, despite the fact that the salary offered in New Jersey would buy far fewer goods (especially housing) than the salary we offered in Michigan.

    There was clearly a lot of naivete about the different price levels in the two locations. But this was information easy to get, and one would think that expending the effort in such a life-determining decision would be a no-brainer. But apparently the higher nominal salary was enough to determine the decision.


  3. 3 David Glasner June 29, 2012 at 9:30 am

    Ritwik, I don’t regard my view of expectations as necessarily adaptive, and I don’t think that it is necessarily inconsistent with rational expectations unless you believe that rational expectations implies that expectations are rationally revised continuously. But I am a fan of Hicksian temporary equilibrium, so I believe that expectations should be held constant over some finite period and then revised between periods. You can use whichever model of expectations formation you want in deriving the between-period revisions.

    David, In the real world we see apparent failures of rationality all the time. Economists are very reluctant to make the results of their models depend on such deviations from rationality. It’s considered a form of cheating.


  4. 4 Tas von Gleichen June 30, 2012 at 10:26 am

    We should get rid of the minimum wage law. Milton Friedsman advice is the way to go.


  5. 5 Saturos July 3, 2012 at 12:03 pm

    David, it seems that your theory only explains wage stickiness in the very short run. You abolish money illusion by claiming that workers rationally take changes in nominal wage offers as being equivalent to changes in real wage offers, with price level expectations held constant over some interval. Yet these workers should eventually observe the actual price level, and revise their expectations accordingly. If the economy goes into a depression, for instance, workers should become much less reluctant to take nominal hourly pay cuts fairly soon. I don’t know if your theory can explain graphs like this:
    And you need much more sophisticated microeconomics to explain why workers “choose unemployment” instead of “wing-walking”: My own views, for what it’s worth, lie with Scott Sumner:


  6. 6 David Glasner July 3, 2012 at 7:52 pm

    Tas, I don’t disagree, but even after a big increase in the minimum wage a few years ago, the minimum wage is still lower in real terms than it was in the 1950-80 period.

    Saturos, I think that there are many sources of wage rigidity, partly institutional, partly conventional, partly legal, partly political, and partly expectational. All that my rendition of the Alchian take on Keynes (filtered through Earl Thompson) is asserting is that even abstracting from all the other sources of wage rigidity, there could still be a totally rational explanation of Keynesian involuntary unemployment. On unemployment vs. wing-walking, there may be more sophisticated models. The question is to explain cyclical unemployment how realistic do we want the model to be. If we can get cyclical unemployment out of a model in which there is no wing-walking, does my macro model also have to explain why it’s rational to choose unemployment rather than wing-walk? I think for the purposes of a macro model we don’t need to work out all the details of the micro model, especially if there are micro-explanations in which employee/employer relationships are long-term relationships in which there is an implied promise of job security.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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