Question

Some politicians have suggested tying the minimum wage to the consumer price index (CPI). Using the AD/AS diagram, what effects would this policy most likely have on output, the price level, and employment?

Short answer

Tying the minimum wage to the CPI can have different effects on output, price level, and employment. When the minimum wage increases with a rising CPI, it leads to higher labor costs for firms, causing a decrease in aggregate supply (AS), which results in a decrease in output, increase in the price level, and higher unemployment. Conversely, when the minimum wage decreases with a falling CPI, it leads to lower labor costs for firms, increasing the AS, which results in increased output, decreased price level, and lower unemployment.

Step-by-step solution

Understand the AD/AS model and the minimum wage policy

The AD/AS model is a way to visualize the interaction between aggregate demand and aggregate supply in an economy. AD represents the total quantity of goods and services demanded by households, firms, and the government. AS represents the total quantity of goods and services supplied by firms in response to the price level. The minimum wage policy refers to the lowest amount of compensation that an employer can legally pay their employees per hour of work. If the minimum wage is tied to the CPI, it means that minimum wage adjustments will be made as the CPI increases or decreases, reflecting inflation or deflation in the economy.

Analyze the effect of minimum wage policy on AS

When the minimum wage is tied to the CPI, it means that when the CPI rises, the minimum wage will increase, leading to higher labor costs for firms. The higher labor costs imply that firms will cut back on hiring and possibly let go of minimum wage employees. This results in a decrease in the quantity of goods and services supplied, causing the AS curve to shift to the left. Conversely, if the CPI falls, the minimum wage will decrease, leading to lower labor costs for firms, which will then increase the quantity of goods and services supplied, shifting the AS curve to the right.

Analyze the effect of minimum wage policy on output

When the economy experiences a decrease in AS due to a rise in the minimum wage, there will be a decrease in the level of output, since the quantity of goods and services supplied will be lower. On the other hand, if there is an increase in AS due to a fall in the minimum wage, the level of output will then increase, as the quantity of goods and services supplied will be higher.

Analyze the effect of minimum wage policy on the price level

When there is a decrease in AS, the price level in the economy will rise since there will be less supply of goods and services relative to demand. This is referred to as cost-push inflation. Conversely, when the AS increases because of a decrease in minimum wage, the price level will fall, reflecting a lower cost of production and higher supply of goods and services.

Analyze the effect of minimum wage policy on employment

When the minimum wage is tied to the CPI and increases, firms will respond by either letting go of minimum wage employees or cutting back on new hires, which will result in increased unemployment. On the other hand, when the minimum wage decreases in response to a decrease in the CPI, firms will likely increase hiring to take advantage of lower labor costs, leading to a decrease in unemployment. In conclusion, tying the minimum wage to the CPI can have different effects on output, price level, and employment depending on whether the CPI is increasing or decreasing. An increase in the minimum wage due to a rise in the CPI will likely result in a decrease in output, an increase in the price level, and an increase in unemployment. Conversely, a decrease in the minimum wage due to a fall in the CPI will likely result in increased output, decreased price level, and decreased unemployment.