Effect of minimum wage on economic growth, inflation and AD/AS

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 2018, the UK minimum wage was set at £7.83 an hour for workers over 25. Higher wages increase incomes and potentially cause higher consumer spending. However, there is a danger a minimum wage can cause higher unemployment, which would cause lower economic growth.

Effect 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

n-minimum-wage

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 excess supply of labour (Q3-Q1). This is known as real wage unemployment)

It is debatable whether a minimum wage actually causes unemployment. In period 2010-17, UK unemployment has fallen to 4.5% – despite 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.

AD/AS analysis

ad-increase

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.

SRAS-shift-left

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:

  1. Higher spending by workers (demand pull inflation)
  2. 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-1970

UK inflation since 1997 has been low. The spikes in 2008-11 were due to cost-push factors (oil prices, devaluation) not rising wages.

Overall

In the real world, I think 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 if it was increased to £10, 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

UK_national_minimum_wage_percentage_changes_1999-2010.svg

Source Splash, Wikipedia, CC, SA.

Unemployment

uk-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.

Related

By on February 25th, 2019

7 thoughts on “Effect of minimum wage on economic growth, inflation and AD/AS

  1. All though I agree with most of the economic facts
    I disagree with low spendeture involving unemployment when it costs local government more in spendeture in social housing, benefits, education and support in welfare if you take that to retail and grocery then surely unemployment costs more

    1. I am not rich at all. I am a blue collar worker. I think minimum wage should be zero because the higher the wages the higher everything goes up. Then your back at square one in poverty. What ever the minimum wage is that’s poverty level because that’s the lowest your allowed to make there for the prices of everything goes up even house rent and utilities. Companies have to pay workers more so they have to charge more so the company can make a profit and that’s even assuming that you work harder.

      1. Nice try Kendall but your argument presumes nobody is currently making a profit. Only if margins were everywhere razor thin would firms need to raise the cost of goods or services immediately. Clearly this isn’t the case as there continues to be record profits in many countries with a minimum wage. Ultimately the existence of a minimum wage disrupts the natural tendency of the free market to pay survival wages to the lowest caste of society at the expense of the profits of those at the top. And even in industries with thin margins I’m ok paying more. I’m ok forgoing a bigger house or that second cruise per year so that the working poor are able to afford a night out to the movies or Macdonald’s once a month. Why aren’t you?

  2. What is not factored in this article – or any article – is the degree to which a certain area of employment is very labour intensive and limitations on improved automation.

    For example with manufacturing there’s the possibility of increased automation to keep the cost of a item down and therefore minimising the effects of a high minimum wage.

    But with care of the elderly – front line face to face care involves an actual person. There’s quite limited scope to reduce this. And is reducing it a good thing?

    As the minimum wage gets higher and higher – as it has – the cost of care will become prohibitive with currently little chance of significantly saving costs through automation.

    It means a lot of vulnerable elderly people having to fend for themselves as they won’t be able afford the cost of care.

  3. Ofcourse,minimum wages causes unemployment,but it depends on companys’ demand of of labour elasticity.If labour is inelastic than efew workers will loss their jobs,rather than if its labour demand is elastic ,means it has substitute factors to use as factor of priductions.In reality minimum wages are badly if there is no other market failures such as: labor exploitation,employers have most advantage /profit,what do we call dispropationate factor price.At that time there must be intervention to reduce income share distortion,by under pricing capital owners and over pricing labor wages.

  4. Minimum wages aren’t just a random number plucked out of thin air. It encompasses the average cost to be a contributing member of society. We cannot have people driving to work in stolen or unregistered cars. We cannot have people coming to work without food or having slept on a park bench each night. Poverty is linked with chronic health problems. The last thing firms want is to have employees with bronchitis because they can’t afford a car so they hitchhike to work and often get stuck in town with no where to sleep and nothing to eat. So the benefit of paying someone less than what it costs to live would likely create significant issues.

Leave a Reply

Your email address will not be published. Required fields are marked *