Answer to Question #163698 in Macroeconomics for Prime

Question

In the light of Keynes's view about the difference between risk and uncertainty, explain each of the following ideas from Keynes:

a: It might be rational (rather then simple illusion) for workers to make labor supply decision based on relative money wages rather than real wages;

b: Households base their consumption and savings decisions on current income rather than wealth

Answer 1

Solution:

a.). According to Keynes's general theory, workers should base their decisions on rationality, which states that decisions being made should be based on the best information available and from past trends. There is the issue of relative-wage rigidity, where the role of real wage is not so relevant in determining output and unemployment. First, the real wage is not the only determinant of the labor supply, and second and most essential, the real wage is not directly fixed by economic agents through bargaining. According to Keynes, any individual or group of individuals who consent to a reduction of money-wages relative to others will suffer a relative reduction in real wages, which is a sufficient justification to resist it. On the other hand, it will be impractical to resist every reduction on real wages due to changes in the purchasing power of money, which affect all workers alike. Relative wage is the best determinant of understanding actual unemployment and its fluctuations, and workers should always base their decision on the prevailing market wages and trends.

 

b.). According to the Keynesian consumption function, the amount of household consumption relates to the level of income. When the household’s income rises, consumption also rises relative to the increase in income. Consumption changes in response to the change in income. Since the demand for a specific good depends upon its price, similarly consumption of households depends upon the level of income. It should be noted that, as the income rises, consumption also rises but not as much as the income. According to Keynes, the reason why consumption rises less than income is that part of the increment in income is saved. Consumption demand depends on income and propensity to consume. With every increase in income, a portion is consumed and the households save the rest. Households are induced to save for various factors such as; to provide for unforeseen contingencies, for investment purposes, and to accumulate large wealth which will increase their social status and give them the incentive to consume more in the future. Although the consumption function also depends on the wealth of households, the absolute level of current income is the important factor that determines the consumption of the households and the amount saved according to Keynes.