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 consumer price index (CPI) would result in a decrease in short-run aggregate supply (SRAS) due to increased wages and production costs. This shift in SRAS leads to a new equilibrium with lower output, higher price levels, and possibly increased unemployment in the short run.

Step-by-step solution

Understanding the policy's effect on aggregate supply

Firstly, when the minimum wage is tied to the CPI, it means that wages will increase as prices rise, ensuring that the real value of the minimum wage remains constant. In other words, this policy aims to maintain workers' purchasing power as the overall cost of living increases. This change in the minimum wage will impact the aggregate supply (AS) curve. Since an increase in wages raises production costs and reduces the profitability of firms, the aggregate supply in the short-run (SRAS) will decrease. In other words, the SRAS curve will shift upward and to the left.

Analyzing the effect on aggregate demand and equilibrium

In response to a decrease in short-run aggregate supply, the new equilibrium will be established at a higher price level and a lower output level. Note that the aggregate demand (AD) curve remains unchanged as the policy directly affects the wages and not the demand for goods and services.

Assessing the effects on output, price level, and employment

As the SRAS curve shifts upward and to the left due to the increase in wages, the new equilibrium will have the following consequences: 1. Output: The lower output level at the new equilibrium indicates that the total production of goods and services in the economy has decreased. This reduction in output can contribute to slower economic growth. 2. Price level: The higher price level at the new equilibrium reflects an increase in the general price level in the economy. As wages increase to match the CPI, firms pass on the higher labor costs to consumers, leading to higher prices or inflation. 3. Employment: Since firms face higher labor costs, they may reduce the number of workers employed to cut down their production costs. This reduction in workforce might lead to a higher unemployment rate in the short-run. In conclusion, tying the minimum wage to the consumer price index (CPI) using the aggregate demand and aggregate supply diagram would most likely lead to a decrease in output, an increase in the price level, and a possible increase in unemployment in the short run. However, it is essential to consider the broader policy implications and other factors before drawing a final conclusion on whether this policy is beneficial or not.