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 in the form of 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, or 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 too 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 causes 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 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 was 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, a book published in 2018 by Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen entitled, Inflation Targeting: Lessons from the International Experience delve 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.