What Is the Wage-Price Spiral?
The wage-price spiral is a macroeconomic theory explaining the cause-and-effect relationship between rising wages and prices, or inflation. As rising wages increasedisposable income, demand for goods rises, triggering prices for goods to move higher.
Rising prices then increasedemand for higher wages, which leads to higher production costs and further upward pressure on prices,creating a conceptual spiral.
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 monetary policy to achieve and sustain a set interest rate.
Inflation
The wage-price spiral 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. A perpetual loop or cycle ofconsistent priceincreases is created. The wage-price spiral reflectsthe causes and consequences of inflation,and it is, therefore, characteristic ofKeynesian economic theory.
The wage-price spiral is also known as the cost-push origin of inflation.
How a 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 livingselect 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 increases, consumers within the economy will purchase more products, which would increase demand. The risein aggregate demand and the increased wage burden cause businesses to increase the prices of products and services.
In Jan. 2024, 22 states increased their minimum wage. States with hourly rates that match or exceed $15 per hour include Maryland, New Jersey, New York, California, Connecticut, Massachusetts, and Washington.
Although wages are higher, increasing prices causes workers to demand higher salaries. If higher wages are granted, a spiral where prices increase may occur,repeating the cycle until wage levels can no longer be supported.
Stopping a Wage-Price Spiral
A wage-price spiral often makes inflation higher than is ideal. The Federal Reserve in the U.S. aims to sustain an inflation rate of 2%. Governments tackle an 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.
The United States has used monetary policy to curb inflation but sometimes triggered 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.
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. In 2018, Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen argued in Inflation Targeting: Lessons from the International Experience, the advantages and disadvantages of inflation targeting and concluded that governments should use their discretion based on the circ*mstances when deciding to use inflation targeting as a tool to control the economy.
What Is Monetary Policy?
Monetary policy is a set of tools a nation'scentral bankhas available to promote economic growth by controlling the overall supply of money available to the nation's banks, consumers, and businesses. The U.S. Treasury Department can create money, but the Federal Reserveinfluencesthe supply in the economy through open market operations (OMO) by buying financial securities when easing monetary policy and selling financial securities when tightening monetary policy. The central bank may increase interest rates on borrowing to discourage spending or force down interest rates to inspire more borrowing and spending.
What Is the Difference Between the U.S. Treasury and the Federal Reserve?
The U.S. Treasury and the Federal Reserve are separate entities. The Treasury manages the money coming into and out of the government. The Federal Reserve's primary responsibility is to keep the economy stable by managing the supply of money in circulation. The Department ofthe Treasurymanages federal spending. It collects the government's tax revenues, distributes its budget, issues its bonds, bills, and notes, and prints money. 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.
What Is Inflation Targeting?
Inflation targeting is a central banking policy that adjusts monetary policy to achieve a specified annual inflation rate. 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.
The Bottom Line
The wage-price spiral is a perpetual cycle where rising wages create rising prices and vice versa. To target inflation, central banks use monetary policy, the interest rate, reserve requirements, and open market operations to curb the wage-price spiral.
