Question

Q5 25 points) 5)- Consider if in a given economy, the parliament approves an increase in minimum wage. Starting from the initial medium run equilibrium, discuss the effects of this policy in following questions. (Total 25 points) a)- Using a set of WS/PS curves, and only in labor market, in step by step way, explain the impacts. (6) b)- Using the aggregate supply and demand (AS/AD), and IS/LM curves, show the short and medium run equilibrium points. [No explanation. Only neat and well-marked graphs are acceptable] (6) c)- In a step-by-step way and in the right order explain what happen to the economy in short run. Make sure you discuss, among other variables, unemployment rate, real wage, and consumption. (6.5) d)- In a step-by-step way and in the right order explain what happen to the economy in medium run. Make sure you discuss, among other variables, unemployment rate, and real wage. (6.5)

Answer 1

a) WP-PS model explain the structural unemployment in the economy. Under certain circumstances the government increase the minimum wage rate. This rise in wage rate attracts more workers to the labour market and the WS curve will shift to right. WS WS W/PO W/P1 PS YO Y1 Employment rate If the minimum wage rises, the employment rate in the labour market increased and the level of real wage fall down. With simple mathematical concept, if the numerator rises with no change in denominator. The value of the whole term will fall down. So the real wage will fall down with rise in minimum wage rate. b) With rise in minimum wage rate, more labours will be attracted towards the market. This will increase the employment level and also there is rightward shift in the AD curve. The AD curve rises with no change in aggregate supply. This shift will raise the price level and the output level. AS P1 PO AD' AD YO Y1 Quantity The equilibrium point will shift from E to E'. This rise in AD is mainly due to the rise in employment and the production level. When more labours come to the market, the

productivity will increase. This will increase the level of production and the producer is willing to sell their products in high price. This is depicted in the given above figure. In case of IS LM model, the IS curve will shift right with rise in investment occurred due to the high level production. When the investment rises, the investment will fall down and the total output will increase. LM 11 ro IS IS Output The higher rate of rise in investment and output will raise the level of interest rate with no change in the LM model. The level of output increased from YO to Y1. c) In short run, the rise in minimum wage rate will attract more workers to the market and this will increase the supply of labour in the market. The exiting workers efficiency and productivity will increase with the rise in minimum wage rate. The higher supply of labour will increase the level of production and this will lead to economic development. This rising minimum wage will increase the demand for goods and services. This will increase the aggregate demand also. d) Medium run is the period of transition. Thus the rise in minimum wage rate will increase the employment in medium run and the price effect will be shown in an increasing rate. Thus the income effect will be greater than the substitution effect.