How does the minimum wage affect aggregate demand/aggregate supply and macroeconomic factors such as inflation, unemployment and economic growth?
A minimum wage is the statutory minimum wage that employers can pay per hour. In 2026, the UK minimum wage will be £12.71 an hour for workers over 21. It means the minimum wage in the UK has increased faster than inflation, since it was introduced in 1999.
The NMW has increased from £3.60 to £12.71 (2026). If it had increased with inflation it would be worth £8.60Higher wages increase incomes and are likely to cause higher consumer spending. A significant increase in minimum wages could lead to higher growth. It could also contribute towards inflation for two reasons
- Higher costs for firms
- Higher spending by workers.
However, the minimum wage is only one factor that affects growth and inflation. In the real world, the UK has seen above inflation increases in the minimum wage without any negative impact on inflation or unemployment – but only negligible impact on economic growth.
Effect of higher minimum wages on economic growth
If workers receive a pay increase, then there will be a rise in consumer spending. Low-income workers are likely to have a higher marginal propensity to consume (in other words they spend high % of extra pay). This could also cause a multiplier effect, with higher spending causing knock-on effects to elsewhere in the economy; this should help boost economic growth.
However, if we assume labour markets are competitive and if we assume that a minimum wage does cause lower employment, then rising unemployment will have a negative impact on aggregate demand. People who become unemployed would spend less, leading to lower aggregate demand.
Diagram showing a minimum wage above the equilibrium
If labour markets are perfectly competitive and if there is a national minimum wage (NMW) above the equilibrium wage, you would expect a fall in demand for labour (Q1 to Q2), and therefore, there would be an excess supply of labour (Q3-Q1). This is known as real wage unemployment) However, to complicate matters labour markets are often not perfectly competitive, but exhibit signs of monopsony power (where firms have market power in setting wages) If firms have monopsony power, they pay wages below the equilibrium and so min wages don’t cause unemployment.
Empirical evidence
It is debatable whether a minimum wage actually causes unemployment. In period 1997-2025 UK unemployment has fallen to 5% – despite above-inflation increases in the minimum wage. Therefore, overall, the higher minimum wage in this period has probably had a positive impact on aggregate demand – especially given how real wage growth has been low and consumer spending weak. Even modest rises in the national minimum wage make a big difference to disposable income and contributed to higher spending.
Underemployment?
However, since the rise in national minimum wage, the UK has seen a rise in under-employment – the number of people who want more hours. The effect of increasing minimum wage may well be for employers to offer shorter working weeks and/or more flexible working hours. For example, delivery drivers given flexible contracts to minimise the hours spent doing the job.
AD/AS analysis
Higher wages enable higher consumer spending and a rise in AD.
Effect on inflation
From the perspectives of firms, an increase in the minimum wage would increase their costs of production. Also, not only will firms have to increase the wage of workers on the minimum wage, but if they seek to maintain wage differentials – they may need to increase wages of more qualified workers – earning just above the minimum wage.
In this case, a minimum wage could lead to firms passing wage rises onto the consumers in the form of higher prices. This will cause SRAS to shift to the left and higher inflation. Also, if higher minimum wages leads to an increase in consumer spending, it could cause a degree of demand-pull inflation as well.
In theory, a higher minimum wage could cause inflation for two reasons:
- Higher spending by workers (demand pull inflation)
- Higher costs for firms, leading to wage-push inflation.
However, in reality, the inflationary impact of a rise in a minimum wage is likely to be muted.
- As a percentage of a firm’s overall costs, the minimum wage bill is only a small component.
- Also, given the low inflationary pressures, there is also a pressure for firms to absorb the wage increases without increasing prices (reduce profit margins).
- Also, in theory, firms could respond to higher minimum wages by investing in capital to raise labour productivity and so will be able to afford the higher wages – without increasing prices.
UK inflation since 1999 has been relatively low. The spikes in 2008-11 were due to cost-push factors (oil prices, devaluation) not rising wages. The spike in 2022 was due to oil price, end of covid.
Overall
In the real world, a minimum wage would have only a marginal impact on AD/AS analysis.
- Firstly, a minimum wage may not cause any unemployment. Labour markets are not perfectly competitive but have a degree of monopsony power.
- Demand for labour may be wage inelastic. Firms just pay higher wages and there is little fall in demand.
- Only one in twelve workers are affected by a minimum wage. (though the percentage of workers impacted by the minimum wage is forecast to rise as the minimum wage is set to rise.
- If anything, I would expect a minimum wage to increase AD – with a higher NMW some workers would receive higher real income and spending would rise.
- I’m doubtful, given recent experience, that the UK Minimum wage causes any significant levels of unemployment. Though as it rises faster than inflation to £12.71, this might need to be revisited.
- Overall, the effect on inflation would be fairly limited because a minimum wage would only alter AD by a small amount.
Essentially a minimum wage has little macroeconomic effects (unless, it was a really big increase in the minimum wage)
Empirical evidence on minimum wages and Unemployment
Effect on Unemployment
Unemployment in the UK. The minimum wage was introduced in 1997 when unemployment was around 6%. There was a sharp rise in 2008-10 due to the great recession. But, has fallen sharply since 2012 – despite weak growth and increased national minimum wage.
The UK rate of unemployment at 4.5% is the lowest since the 1970s – suggesting the UK has a lower natural rate of unemployment. Many factors affect employment apart from minimum wages. But, there is little evidence to suggest increasing minimum wage 60% since 1997 has led to a significant rise in real wage unemployment.
In the US, a combined study of different studies into raising the minimum wage found that
Overall, these findings suggest that the level of minimum wages that we study—which range between 37% and 59% of the median wage—have yet to reach a point where the job losses become sizable.” (Effect of minimum wages on low wage jobs, 2019)
Effect of raising the minimum wage in California
California was the first US state to push for significant increases in the minimum wage. It has had a significant impact on low-wage sectors, such as restaurants, retail and the health sector. A study by Berkeley.edu (2017) found a limited effect on the overall employment and inflation picture, but concentrated effects on particular low paid sectors.
A $15 statewide minimum wage by 2023 would generate a significant increase in earnings for about 5.26 million workers (38% of workforce) in California while creating a small price increase borne by all consumers.
“Total wage costs would increase by 15.7 % for restaurants and 2.8 % across all employers.
Evaluation
The minimum wage has increased but average wages haven’t. Therefore, there has been wage compression. This is important for looking at effect on aggregate demand
Average disposable incomes have stagnated, suggesting that those on the minimum wage are some of the few workers to actually get increase in real wages.
Related
About The Author
Thank you Kendall for saying what no politician says… Individuals who get a raise because of an artificial foundation will only feel good until the adjustment of costs settle… Then those same people who felt so good settle back to the bottom of wage earners… No to mention it devalues any person’s income who makes anything above the current minimum wage. Unfortunate that reality doesn’t strike the masses and that politicians use this farce as a wedge issue in hopes that it’ll result in votes.