Question

AD-SRAS-LRAS model of the economy. Assume the SRAS curve is upward sloping

1. Congress has debated raising the minimum wage to over $10 per hour. Doing so would permanently increase the production costs to businesses, especially those relying on lower-skilled workers. Use the AD-AS model to discuss the macro impacts on the price level, real GDP and unemployment

2.The Federal Reserve has decided to design a policy response to the shift in part (a). What policy options are available and what are the associated trade-offs? Use an AD- AS diagram to support your opinion

Answer 1

1) If production costs are increased then there will be a reduction in production. This will shift the LRAS curve and SRAS to the left. Price level rises and real GDP falls in the short run. This raises the unemployment and causes stagflation

2) The Fed would use expansionary monetary policy of raising money supply and reducing the interest rate if it wishes to stabilize the output. It would use contractionary monetary policy of reducing money supply and raising the interest rate if it wishes to stabilize the inflation. Hence there will be a trade off between inflation and output stability.