Question

According to standard theory (no extremes), (a) predict the effect of an exogenous increase in the wage rate on consumption, unemployment and interest rates. Explain. (b) Predict the effect of a tax reduction on the same three variables as in (a).

Answer 1

Changes in the wage rate have direct impact on the employment, consumption and interest rate.

With the increase in the wage rate, labours are paid highly which increases their spendings on goods. So their consumption increases considerably.

However, it has a negative impact on employment. Increase in the wages makes the cost of production of the goods high which tends the industry to lower employment rate and thus the unemployment tends to increase because labours are made to leave the job.

The increase in the wage rate is due to decrease in the interest rate because the demands and spending of the labour was increased and thus the firm maximises its profit and increased wage rate but when the wage rate is increased without any interference of interest rate then due to inflationary pressure i.e, hight extent increase of demand, the interest rate would be higher.

Tax rate are levied on each and every consumer goods.

With the reduction in the tax rate, the price of the goods are increased due which there is decrease in the demand rate and so the consumption of the consumers are reduced.

The unemployment rate is reduced beacuse the tax reduction causes demands to increase which maximises the revenue of the firm. The capital of the firm increases and thus they increase the level of employment in the firm.

With the reduction in the tax rate, calculating the interest rates is uncertain but the reduction will lead to more demands and supply of labour which in turn will increase the capital and the investments, rate making the interest rate low.