Using AD/AS diagrams, analyse the likely impact on an economy of a general rise in wage costs and an increase in the money supply by the Federal Reserve Bank.
Aggregate supply (AS) measures the volume of goods and services produced within the economy at a given price level. A fall in worker productivity or firms paying higher wages to their employees can bring about a rise in wage costs. If wage costs rise, the result will be higher prices. This is explained in the diagram below:
Increase in Wage costs Graph
This is an example of cost-push inflation. Cost-push inflation is a type of inflation that occurs due to an overall rise in costs for factors of production. Cost-push inflation causes an inward shift of the SRAS. Hence a fall in SRAS causes the real output to decrease, and the general level of prices to rise in ceteris paribus. As seen in the diagram short run Aggregate Supply decreases from SRAS1 to SRA2 causing the price to increase from P1 to P2, and the real income to increase from Y1 to Y2.
If the Federal Reserve back decides to increase the money supply, like for example by using expansionary monetary policy. An increase in the money supply results in a decrease of interest rates. The extra money increases the purchasing power of business, households and also the government because everyone is able and willing to buy more at the same price level, hence all the factors of AD (consumption, investment, government purchases and even net exports) increase resulting in an increase in aggregate demand. This increase in AD is shown in the graph below: