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I am a high-school student...sorry if this is a very simple question.

Is it due to the fact that, as there is more money in the economy, firms can afford to pay higher wages/employ more people? But surely this effect is more or less cancelled out by the increases in average price level within an economy?

Thank you in advance.

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In a nutshell, a higher GDP is the very same as an increase in average incomes, at least if the population remains constant. If there is more stuff produced and consumed, overall income is higher and average income as well.

As you rightly point out, since income is measured in monetary terms, one has to correct for price increases. And this is usually done. Whenever you hear 'GDP has increased', this better be in real terms, i.e. in constant prices. In nominal terms, GDP (as well as tax revenues) are increasing almost every year, which renders nominal comparisons usually meaningless.

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In the short term, economic growth is caused by an increase in aggregate demand (AD). An increase in AD will cause a higher level of real GDP.

If GDP is increasing then that most likely mean that more people are buying goods and services which could result in more people working and earning more income.

However, it is possible for GDP to increase and average wages to stay the same as the previous year or even decline.

To answer your first question; yes if there are more money in the economy most firms could afford to pay higher wages/employ more people but that doesn’t always mean they will.

There is a term that is linked to your second question which is wage-price spiral. As wages increase, so too does a consumer's propensity to both save and consume. As consumers within the economy purchase more products, this would increase demand. The rise in aggregate demand and the increased wage burden causes businesses to increase the prices of products.

If higher wages are granted again, a spiral where prices subsequently increase may occur repeating the cycle until wage levels can no longer be supported.

To answer your second question, yes higher prices would cancel those effects made with increase in income (as GDP increases) in the long run.

Anyone else would like to add?

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