Wage-price spiral

Definition

A wage-price spiral refers to a situation where rising wages lead to increased production costs for businesses, which then raises prices for goods and services, causing workers to demand even higher wages to keep up with inflation. This cycle can create persistent inflation as each round of wage increases feeds into further price increases. The spiral effect demonstrates the interconnection between labor costs and inflationary pressures within the economy.

5 Must Know Facts For Your Next Test

1. The wage-price spiral can be triggered by factors such as strong economic growth or supply chain disruptions that lead to increased demand for labor.
2. Once the wage-price spiral starts, it can be difficult to control without intervention from policymakers, like raising interest rates or implementing wage controls.
3. Workers often expect their wages to keep pace with rising prices, leading to a cycle where anticipated inflation results in actual inflation.
4. The wage-price spiral can disproportionately affect lower-income households, as they tend to spend a larger portion of their income on essential goods and services, which are subject to rising prices.
5. To combat a wage-price spiral, central banks may increase interest rates, aiming to slow down the economy and reduce inflationary pressures.

Review Questions

• How does the wage-price spiral illustrate the relationship between wages and inflation?
  • The wage-price spiral illustrates the relationship between wages and inflation by showing how increases in wages can lead to higher prices, which then compel workers to demand even higher wages. This creates a continuous loop where each wage increase contributes to further inflation. As businesses face higher labor costs, they pass these costs onto consumers in the form of higher prices, reinforcing the cycle of inflation.
• Analyze how external economic factors can initiate a wage-price spiral and its implications for labor markets.
  • External economic factors like sudden increases in demand for goods or disruptions in supply chains can initiate a wage-price spiral. For instance, if an economy is growing rapidly, businesses may raise wages to attract workers. However, as they pass on increased labor costs through higher prices, consumers face inflation, prompting further wage demands. This dynamic can lead to tight labor markets and difficulties in managing inflationary expectations among workers.
• Evaluate the long-term effects of a persistent wage-price spiral on overall economic stability and policy responses.
  • A persistent wage-price spiral can undermine economic stability by creating an environment of continual inflation that erodes purchasing power and complicates monetary policy. As inflation expectations become ingrained in economic behavior, central banks may struggle to control inflation without significantly slowing economic growth. Policymakers might respond with aggressive interest rate hikes or fiscal measures aimed at controlling wages and prices, but these responses can have side effects like increasing unemployment or stifling economic growth.

Related terms

inflation: The rate at which the general level of prices for goods and services rises, eroding purchasing power.

cost-push inflation: Inflation that occurs when overall prices increase due to rising production costs, such as wages and raw materials.

labor market: The supply and demand for labor, where employers seek to hire workers, and individuals offer their skills in exchange for wages.