Wage-price spiral

Definition

The wage-price spiral refers to a situation where rising wages lead to increased production costs, which then cause businesses to raise prices, resulting in higher inflation. This creates a cycle where workers demand higher wages to keep up with rising prices, further escalating production costs and perpetuating inflation. The spiral can create challenges for economic stability as it intertwines labor costs and price levels.

5 Must Know Facts For Your Next Test

1. The wage-price spiral can lead to sustained inflationary pressures within an economy, making it difficult for central banks to control inflation without raising interest rates.
2. In times of economic growth, strong demand for labor can push wages up, which may trigger a wage-price spiral if businesses respond by increasing prices.
3. The wage-price spiral can be particularly pronounced in sectors with strong labor unions, as these groups often negotiate higher wages that can influence overall wage levels in the economy.
4. To break the cycle of a wage-price spiral, policymakers may need to implement strategies such as monetary tightening or fiscal measures to reduce demand.
5. The expectation of future inflation can perpetuate the wage-price spiral, as both employers and employees anticipate higher costs and adjust their behavior accordingly.

Review Questions

• How does the wage-price spiral illustrate the relationship between wages and inflation in an economy?
  • The wage-price spiral illustrates a direct relationship between wages and inflation as rising wages lead to higher production costs for businesses. In response, businesses increase their prices to maintain profit margins, which contributes to overall inflation. This prompts workers to demand even higher wages to keep up with rising living costs, creating a continuous cycle that can significantly impact economic stability.
• What role do expectations of future inflation play in perpetuating the wage-price spiral?
  • Expectations of future inflation can significantly impact the wage-price spiral by influencing how both employers and employees behave. If workers anticipate that prices will rise, they are more likely to demand higher wages preemptively. Similarly, businesses may raise prices sooner than necessary if they expect costs to increase, thus contributing to the cycle of wage increases followed by price hikes. This anticipation reinforces the spiral and makes it harder for policymakers to control inflation.
• Evaluate the effectiveness of monetary policy measures in breaking the wage-price spiral during periods of high inflation.
  • Monetary policy measures, such as raising interest rates, can be effective in breaking the wage-price spiral during high inflation periods. By increasing borrowing costs, central banks can reduce consumer spending and investment, which may lower overall demand for goods and services. This reduction in demand can help stabilize prices and alleviate pressure on wages. However, such measures may also lead to slower economic growth and higher unemployment, creating a delicate balance that policymakers must navigate.

Related terms

Inflation:

A general increase in prices and fall in the purchasing value of money, often measured by the Consumer Price Index (CPI).

Cost-Push Inflation: A type of inflation that occurs when the overall price level rises due to increases in the cost of wages and raw materials.

Demand-Pull Inflation: A form of inflation that occurs when demand for goods and services exceeds supply, leading to an increase in prices.