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that workers agreed to a cut in wages with the aim of reducing unemployment, as the classical analysis of labour market would suggest.  The positive effect described above would be outweighed by a negative aspect of this policy, should we consider the level of aggregate demand in the economy. Due to lower wages, employees would have less money to spend; aggregate demand in the economy would decline, as would sales and prices. This situation would lead towards a recessive spiral with negative expectations and therefore disinvestment and unemployment. The negative consequences on the demand for labour of a depressed economy would easily offset the positive effects of lower pay. This situation can be represented as in graph (b), figure 14.2.  In an economy where the price mechanism is too slow and uncertain to ensure full employment (represented by YF), the fundamental reason for unemployment, according to this view, is the lack of aggregate demand due to wages being too low. Therefore, recommended policies to fight unemployment are policies aimed to sustain wages and aggregate demand.

Policy analysis must be careful in assessing the importance of both components of unemployment, which can vary across countries and overtime.

Q4 The introduction of a national minimum wage has been proposed as a solution to the problem of 'underpaid' workers. How would you expect this measure to affect the level of unemployment?

From the simple analysis of figure 14.2 - a, we assume that a minimum wage is set at (w/p)1, higher than the current one (w/p)0, determined by the market. This gap would create an excess of labour supply and, consequently, would lead to unemployment (represented by section AB).  In a segmented labour market, the minimum wage does not affect skilled and well-paid workers but only low-paid, low-productive jobs.

i) an improvement in the social and economic conditions of those in work occurs, diminishing the number of workers below the poverty threshold.

ii)  the conditions of those (represented by section L1L0 in the figure), who are not able to be employed at the higher minimum wage deteriorates thus creating an insider-outsider situation in the labour market and worsening income distribution among unskilled workers.

Q5 What is meant by hysteresis in the context of unemployment? Discuss the importance of this concept in assessing the economic costs of unemployment.

To understand the concept of hysteresis, we need to start from the definition of the natural rate of unemployment. This is described as the unemployment rate created by institutional and economic rigidities. If rigidities occur (minimum wage and replacement ratio being too high, occupational and geographical immobility, work legislation, tax wedges, rigidities in the product market, asymmetric information), the


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