By Andrew Glover
The Fair Minimum Wage Act of 2007 increased the U.S. nominal minimum wage by 41 percent immediately prior to nominal interest rates hitting the Zero Lower Bound in 2008. I study the interaction of these two events in an extension of the sticky-price New Keynesian model. The minimum wage dampens the contractionary effects of the ZLB by preventing rapid wage deflation, halting the deflationary spiral caused by low aggregate demand. For sufficiently persistent ZLB shocks, the minimum wage generates infinite output gains relative to flexible wages, while GDP losses are reduced by half in a calibrated economy. Increasing the minimum wage at the ZLB is expansionary: accumulated output gains are more than 15 percent in the calibrated economy.
Interesting. I can believe that increasing the minimum wage is expansionary, after all the beneficiaries have a very high propensity to consume. And this becomes particularly important when you hit the ZLB, as policy options are running out. I would not have expected this to that effective a policy.
Hi Christian, thanks for the write up!
In terms of the mechanism and magnitude, there is some of the older Keynesian logic you mention in the hand-to-mouth extension at the end of my paper, but the baseline model is working through real interest rates, not heterogeneous MPCs.
The deflationary spiral that so depresses output at the zero lower bound requires nominal wages to decline even more than prices. If some workers have downwardly rigid nominal wages (and those who earn the minimum wage certainly do) then the average nominal wage cannot decline as much, which leads firms to cut prices less in the face of low demand. In short, you can’t lose money per unit and hope to make it up on volume! This props up prices, which means that real interest rates do not rise as much, which keeps demand from falling as severely.
Raising the minimum wage during the ZLB episode, as the US happened to do this time around, further prevents deflation, which further dampens the rise in real interest rates.