Wage-Price Spiral

What Is the Wage-Price Spiral?

The wage-price spiral is a macroeconomic theory used to explain the cause-and-effect relationship between rising wages and rising prices, or inflation. The wage-price spiral suggests that rising wages increase disposable income raising the demand for goods and causing prices to rise. Rising prices increase demand for higher wages, which leads to higher production costs and further upward pressure on prices creating a conceptual spiral.

The Wage-Price Spiral and Inflation

The wage-price spiral is an economic term that describes the phenomenon of price increases as a result of higher wages. When workers receive a wage hike, they demand more goods and services and this, in turn, causes prices to rise. The wage increase effectively increases general business expenses that are passed on to the consumer as higher prices. It is essentially a perpetual loop or cycle of consistent price increases. The wage-price spiral reflects the causes and consequences of inflation, and it is, therefore, characteristic of Keynesian economic theory. It is also known as the cost-push origin of inflation. Another cause of inflation is known as demand-pull inflation, which monetary theorists believe originates with the money supply.

Key Takeaways

  • The wage-price spiral describes a perpetual cycle whereby rising wages create rising prices and vice versa.
  • Central banks use monetary policy, the interest rate, reserve requirements, and open market operations to curb the wage-price spiral.
  • Inflation targeting is a type of monetary policy that aims to achieve and sustain a set interest rate over a period.

How a Wage-Price Spiral Begins

A wage-price spiral is caused by the effect of supply and demand on aggregate prices. People who earn more than the cost of living select an allocation mix between savings and consumer spending. As wages increase, so does a consumer's propensity to both save and consume.

If the minimum wage of an economy increased, for example, it would cause consumers within the economy to purchase more product, which would increase demand. The rise in aggregate demand and the increased wage burden cause businesses to increase the prices of products and services. Although wages are higher, the increase in prices causes workers to demand even higher salaries. If higher wages are granted, a spiral where prices subsequently increase may occur repeating the cycle until wage levels can no longer be supported.

Stopping a Wage-Price Spiral

Governments and economies favor stable inflation—or price increases. A wage-price spiral often makes inflation higher than is ideal. Governments have the option of stopping this inflationary environment through the actions of the Federal Reserve or a central bank. A country's central bank can use monetary policy, the interest rate, reserve requirements, or open-market operations to curb the wage-price spiral.

Real World Example

The United States has used monetary policy in the past to curb inflation, but the result was a recession. The 1970s were a time of oil price increases by OPEC that resulted in increased domestic inflation. The Federal Reserve responded by raising interest rates to control inflation, stopping the spiral in the short term, but acting as the catalyst for a recession in the early 1980s.

Many countries use inflation targeting as a way to control inflation. Inflation targeting is a strategy for a monetary policy whereby the central bank sets a target inflation rate over a period and makes adjustments to achieve and maintain that rate. However, the book published in 2018 by Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen, Inflation Targeting: Lessons from the International Experience, delved into the past advantages and disadvantages of inflation targeting to discern whether there is a net positive in its use as a monetary policy rule. The authors conclude that there is no absolute rule for monetary policy and that governments should use their discretion based on the circumstances when deciding to use inflation targeting as a tool to control the economy.

What Is Monetary Policy?

Monetary policy is a set of tools that a nation's central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation's banks, its consumers, and its businesses. The U.S. Treasury Department has the ability to create money, but the Federal Reserve, also called the Fed, influences the supply of money in the economy, largely through open market operations (OMO). Essentially, this means buying financial securities when easing monetary policy and selling financial securities when tightening monetary policy. The Fed's preferred securities for OMO are U.S. Treasuries and agency mortgage-backed securities. The goal is to keep the economy humming along at a rate that is neither too hot nor too cold. The central bank may force up interest rates on borrowing to discourage spending or force down interest rates to inspire more borrowing and spending. The main weapon at its disposal is the nation's money. The central bank sets the rates it charges to loan money to the nation's banks. When it raises or lowers its rates, all financial institutions tweak the rates they charge all of their customers, from big businesses borrowing for major projects to home buyers applying for mortgages.

U.S. Treasury vs. Federal Reserve: What's the Difference?

The U.S. Treasury and the Federal Reserve are separate entities. The Treasury manages all of the money coming into the government and paid out by it. The Federal Reserve's primary responsibility is to keep the economy stable by managing the supply of money in circulation. The Department of the Treasury manages federal spending. It collects the government's tax revenues, distributes its budget, issues its bonds, bills, and notes, and literally prints the money. The Treasury Department is headed by a cabinet-level appointee who advises the president on monetary and economic policy. The Federal Reserve is the central banking system of the United States and is run by a board of governors that oversees 12 regional Federal Reserve Banks. Its primary goals are to regulate the nation's private banks and manage the overall money supply in order to keep the inflation rate and the employment rate stable. The Federal Reserve Board is accountable to the U.S. Congress, not the president.

What Is Inflation Targeting?

Inflation targeting is a central banking policy that revolves around adjusting monetary policy to achieve a specified annual rate of inflation. The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability and price stability is achieved by controlling inflation.

Article Sources
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  1. Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen. "Inflation Targeting: Lessons from the International Experience." Accessed Nov. 28, 2020.

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