Inflationary Spiral

Definition

An inflationary spiral is a self-reinforcing cycle of rising prices and wages that can lead to persistent and accelerating inflation in an economy. It occurs when increasing prices prompt workers to demand higher wages, which in turn leads employers to raise prices further, creating a feedback loop that drives inflation upwards.

5 Must Know Facts For Your Next Test

1. An inflationary spiral is often triggered by a supply shock, such as a sharp increase in the price of a key commodity like oil, which then leads to a self-reinforcing cycle of rising prices and wages.
2. The expectation of future inflation can become a self-fulfilling prophecy, as workers and firms try to get ahead of the curve by demanding higher wages and prices.
3. Inflationary spirals are more likely to occur in economies with strong labor unions, indexation of wages to inflation, and a lack of central bank credibility in controlling inflation.
4. Governments and central banks may attempt to break an inflationary spiral through contractionary monetary policy, such as raising interest rates, and incomes policies, such as wage and price controls.
5. Persistent inflationary spirals can lead to hyperinflation, where the currency loses all value and the economy becomes severely disrupted.

Review Questions

• Explain how an initial supply shock can trigger an inflationary spiral.
  • An initial supply shock, such as a sharp increase in the price of a key commodity like oil, can lead to higher production costs for businesses. These businesses may then raise their prices to maintain profit margins. This price increase can prompt workers to demand higher wages to keep up with the rising cost of living. Employers, in turn, may grant these wage increases, leading them to raise prices further to offset the higher labor costs. This self-reinforcing cycle of rising prices and wages is known as an inflationary spiral, which can persist and accelerate if left unchecked.
• Describe the role of expectations in an inflationary spiral.
  • The expectation of future inflation can become a self-fulfilling prophecy in an inflationary spiral. As workers and firms anticipate higher prices, they may try to get ahead of the curve by demanding higher wages and setting higher prices. This can further fuel the cycle of rising prices and wages, as each group tries to protect their purchasing power and profit margins. The central bank's credibility in controlling inflation is crucial in shaping these expectations and breaking the inflationary spiral. If the central bank is perceived as unable or unwilling to rein in inflation, the public's inflation expectations may become entrenched, making the spiral even more difficult to stop.
• Evaluate the effectiveness of different policy interventions in breaking an inflationary spiral.
  • Governments and central banks have several policy tools at their disposal to try to break an inflationary spiral. Contractionary monetary policy, such as raising interest rates, can help reduce demand and slow the pace of inflation. Incomes policies, such as wage and price controls, can also be used to directly limit the extent of price and wage increases. However, the effectiveness of these interventions can be limited, especially if the inflationary spiral has become deeply entrenched and the public's inflation expectations are firmly anchored. In such cases, a more comprehensive policy approach may be required, including a credible commitment to price stability, improved central bank independence, and structural reforms to address the underlying causes of the inflationary pressures. The ultimate success of these interventions will depend on the specific economic and institutional context of the country experiencing the inflationary spiral.

Related terms

Inflation: The sustained increase in the general price level of goods and services in an economy over time.

Wage-Price Spiral: The phenomenon where rising wages lead to higher production costs, which in turn lead to higher prices, further fueling demands for higher wages.

Hyperinflation: Extremely high and accelerating inflation, often reaching thousands or millions of percent per year, leading to a complete loss of confidence in the currency.