Question

In: Economics

Suppose an economist criticizes the Federal Reserve for creating too little inflation over the last few...

  1. Suppose an economist criticizes the Federal Reserve for creating too little inflation over the last few years arguing that employment and output could have been higher under a more expansionary monetary policy. Use the concept of money illusion to explain why this economist might hold this view. (5 pts)
  2. Is this economist more likely to believe that the short-run aggregate supply curve is highly elastic or highly inelastic? (5 pts)
  3. Is this economist more likely to believe that the labor supply curve is highly elastic or highly inelastic? (5 pts)

Suppose this economist believes the minimum wage will not increase unemployment AND employment would be much higher under an expansionary monetary policy. Is there a tension between these views? (5 pts)

Solutions

Expert Solution

A. The concept of money illusion which was developed by Milton Friedman goes like this, Suppose central bank increase the money supply the price level goes up, the employers believe that the price of the goods and services they are selling has gone up. As a result of which they start hiring more workers and wage rate goes up.

And from workers point the labor supply decision made by the workers are based on the some expected price level Pe not on actual price level P. Since at the time of singing the labor contract workers doesn't know what's the actual price level that is going to prevail in the future. So from workers point of view when wage rate W goes up, they think their real wage that W/Pe has increased. As a result of which they supply more labor unaware of the fact that general price level in economy has gone up.

As result of this illusion created by money supply the firms starts hiring more workers to produce more goods and services. Which consequently increases the aggregate output and employment and at the same time reduces the unemployment.

So when an economist is criticizing the federal reserve for creating too little inflation over the last few years arguing that employment and output could have been higher have some merit in his argument as we discussed earlier what money illusion can do.

(b) This economist must be of the view that the short-run aggregate supply curve is highly elastic. If it weren't the case then there was no way output and employment could be changed in short run by illusion.

It is only when the aggregate supply function is highly elastic in short run we can affect aggregate supply, and when price changes aggregate supply changes due to money illusion.

If the short-run aggregate supply curve were to be highly inelastic then arguing that higher inflation could have increase aggregate output and employment doesn't make any sense. Since highly inelastic aggregate supply means that supply doesn't respond to price change, that is no money illusion is there.

So we can with certainty that the economist believes that the short-run aggregate supply curve is highly elastic.

(C) Again using the logic and arguments as we did in part B we can say that this economist believes that labor supply curve is highly elastic. If it weren't the case then there is no way higher wage rate would induce more labor supply and consequently higher employment and output.

And since we are given that this economist believes that higher inflation can increase employment and aggregate output then it must have been the case that he believes the labor supply curve to highly elastic.

Again assume if it weren't the case and the labor supply curve were to be highly inelastic. So when the price level goes up and firms starts to hire more workers by increasing wage rate W, a highly inelastic labor supply would mean that labor supply doesn't respond to increases wage rate and as a result employment doesn't increase nor does the aggregate output. Which is not consistent with the arguments made by the economist to federal reserve.

So we can again say this with certainty that this economist believes that labor supply curve is highly elastic.

A minimum wage rate means that the labor supply curve is perfectly elastic, and the level of output and employment entirely depends on the labor demand curve.

Now when this economist believes that the minimum will not increase the unemployment rate and employment would be much higher under expansionary monetary policy is right. Let's understand this.

When there is minimum wage then our labor supply curve becomes perfectly elastic which means workers are willing to work at a given minimum wage rate W* and the level of employment entirely depends labor demand curve.

So when there is expansionary monetary policy is introduced as a result of which the price level goes up, and again due to money illusion the firms start hiring more workers only this time the wage rate W doesn't go up as a result firms hire more workers since they have to pay the same wage. So under minimum wage rate the unemployment doesn't increase and the increase in employment is much hire under expansionary monetary policy.

There is a tension between this view. When there is a minimum wage and workers are forced to work at the minimum wage rate. The increase in price level would mean that their real wage rate W*/P will go. So the aggregate output and employment increases but the real wages for workers goes down.


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