The wage-price spiral is a self-reinforcing cycle of rising wages and prices that can lead to sustained high inflation. It occurs when workers demand higher wages to keep up with increasing prices, and businesses then raise prices further to maintain profit margins, leading to a continuous upward spiral of wages and prices.
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The wage-price spiral is a key mechanism that can perpetuate and accelerate inflation in an economy.
Indexing, where wages and prices are automatically adjusted to keep pace with inflation, can contribute to and prolong the wage-price spiral.
The wage-price spiral is often associated with cost-push inflation, where rising production costs lead to higher prices.
Policymakers may attempt to break the wage-price spiral by implementing measures such as wage and price controls or restrictive monetary policy.
The wage-price spiral can be particularly problematic in economies with strong labor unions and high levels of indexation, as it can become entrenched and difficult to control.
Review Questions
Explain how the wage-price spiral can contribute to sustained high inflation in an economy.
The wage-price spiral is a self-reinforcing cycle where rising wages lead to higher production costs, causing businesses to raise prices, which then prompts workers to demand even higher wages to maintain their purchasing power. This continuous upward spiral of wages and prices can result in sustained high inflation. The cycle is often exacerbated by the practice of indexing, where wages and prices are automatically adjusted to keep pace with inflation, further perpetuating the spiral.
Describe the role of cost-push inflation in the wage-price spiral and how it can impact an economy.
Cost-push inflation, where rising production costs lead to higher prices, is closely linked to the wage-price spiral. As businesses face increased costs, such as higher wages, they will raise prices to maintain profit margins. This, in turn, prompts workers to demand higher wages, leading to further price increases. This cycle can become entrenched, with cost-push inflation and the wage-price spiral feeding off each other and causing sustained high inflation. Policymakers may struggle to break this cycle, as measures to control wages or prices can be politically challenging and may have unintended consequences.
Analyze the potential impact of indexing on the wage-price spiral and discuss strategies policymakers might use to address this issue.
Indexing, the practice of automatically adjusting wages, prices, or other economic variables in response to changes in the general price level, can exacerbate the wage-price spiral. By maintaining the link between wages and prices, indexing can make the spiral more persistent and difficult to break. Policymakers may attempt to address this by implementing temporary wage and price controls, or by pursuing restrictive monetary policy to reduce inflationary pressures. However, these measures can be politically unpopular and may have unintended consequences, such as creating shortages or distorting market signals. Ultimately, policymakers must carefully balance the need to control inflation with the potential economic and social costs of their interventions.