Answer to Question #212318 in Macroeconomics for Akhona Klanisi

Question

the government proposed reduced spending in form of a slashed public wage bill. Use the AD-AS framework to explain logically the potential effect of such a policy move on output and prices. [Make reference to what happens to the curves but NO drawings of graphs required].

a.      In the short run

Answer 1

Slashing public wage bill means a fall in wage rates which imply a fall in marginal costs. According to the Keynesian, consumers' expenditure falls by the amount of the fall in the wage bill. Wages are paid by entrepreneurs and any reductions in the disbursement of wages by them will leave them at a better financial position.

The result of wage cut at the first stage is only to produce a change in the distribution away from wages in favor of profits .

Explaining this with respect to the AD-AS framework, we find out that:

If the marginal propensity to consume of the entrepreneurial class is equal to that of the wage earning class, aggregate demand for consumer goods will remain unchanged in terms of money, the decrease in expenditure by wage earners being compensated for by the rise in expenditure by profit earners.

Demand will fall to the extent of the fall in the wage bill only if marginal prospensity to consume of wage earners is one and that of profit earners is zero.

If there exists no difference in the consumer functions of wage earners and profit earners, demand remains the same and marginal costs being lower, prices will fall and output will increase in the same proportion as prices have fallen . This is because money income remains the same .

A fall in wage rates will also worsen the inflation- unemployment tradeoff and therefore shift the aggregate supply downwards.