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.

Key concepts

Consumer Price Index

To comprehend how tying the minimum wage to the consumer price index (CPI) impacts the economy, it's crucial to understand what the CPI is. The CPI measures the average change over time in the prices paid by consumers for a market basket of goods and services. Think of it as a way to track inflation.
The CPI is a vital tool for economists and policymakers because it provides a picture of inflation. When politicians suggest linking minimum wage to CPI, they aim to safeguard workers' purchasing power by ensuring wages rise alongside prices.
Thus, the CPI acts as a benchmark, ensuring wages adjust to cost of living changes, maintaining consistency in what workers can buy over time.

Aggregate Supply

The concept of aggregate supply (AS) is fundamental in understanding how tying minimum wage to CPI impacts the economy. Aggregate supply represents the total amount of goods and services that firms in an economy are willing to supply at a given overall price level.
In the short-run, changes to wage policies affect production costs for firms. When wages go up due to CPI adjustments, firms face higher labor costs. This typically leads to a decrease in aggregate supply in the short run (SRAS).
To visualize this, consider the aggregate supply curve shifting to the left. It shows that higher costs reduce firms' output at every price level, making it potentially more expensive to produce goods and services.

Aggregate Demand

Aggregate demand (AD) refers to the total quantity of goods and services demanded across the economy at different price levels. It encompasses consumer spending, investment, government expenditure, and net exports.
In the context of minimum wage adjustments due to CPI, it's important to note that aggregate demand remains unchanged. This is because the policy directly influences wages (a cost factor) rather than consumers' willingness or ability to purchase goods and services.
So, despite changes in aggregate supply, aggregate demand continues to follow its path. Therefore, it is the interplay between unchanged aggregate demand and reduced aggregate supply that determines the new equilibrium in the economy.

Short-Run Economic Effects

Short-run economic effects analyze the immediate impacts of adjusting minimum wages tied to CPI. First, the reduced aggregate supply suggests lower overall production of goods and services, indicating a potential decline in economic output.

• Output: As firms adjust to higher wage costs, they may produce less, leading to a drop in overall economic activity. This can slow down growth.
• Price Level: With higher production costs, firms might raise prices to maintain profits, causing inflation.
• Employment: Increased labor costs could make firms reconsider hiring. They might reduce their workforce, potentially raising unemployment rates short-term.

Ultimately, while aiming to protect workers' income, adjustments can have varied and complex immediate economic impacts.