Wage-Price Spiral

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21 Aug, 2024

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Wage-Price Spiral Definition

The wage-price spiral theory in macroeconomics describes the vicious circle of rising wages and increasing prices. Rising prices generate wage demands that, in turn, shoot up prices resulting in an endless loop of inflation. Unchecked wage-price spiral results in rampant inflation, which may erode the value of a currency resulting in the collapse of an economy.

The theory studies the cyclic relationship between wage hikes and price rises or inflation. The wage-price spiral occurs when inflation becomes expected. It has two key elements—the profit motive of businesses and workers' efforts to catch up with the rising prices. With rising prices, the real income drops, pushing people to demand higher wages. Higher wages drive up the cost of production. So, firms push up the prices of the output to sustain profits. This starts a new cycle of inflation.

Wage-Price Spiral Definition

The wage-price spiral is a cyclical condition where the rise in wages leads to increased prices, resulting in inflation.
The wage-price spiral is both the cause and effect of inflation.
Inflation expectation leads to demand for higher wages that drives the labor cost and thereby the prices, resulting in a wage-price spiral.
Interest rate hikes by the Federal Reserve or central banks can help decrease inflation and stop the wage-price spiral.

Wage-Price Spiral Explained

Wage-price spiral is a theory used to give an insight into the relationship between higher wages and increasing prices or inflation. In common understanding, whenever the wages increase, consumers will have excess cash at their disposal, which will be utilized in two manners—either they will save it or spend it.

Thus, demand surges and increased costs spiral up the prices of goods and services, resulting in higher inflation. It further leads to demand for wage hikes. Thus, it sets off the wage-price cycle.

The important factor for a wage-price spiral inflation loop is that there should be an alternate increase in wages and prices of goods and services. It must be so that the price rise must outdo the wage hike, or the wage hike must outdo the price rise. However, for these things to happen, companies and labor unions should have enough market strength to raise the prices of the goods and services and increase the workers' wages, respectively.

In other words, the theory is a cycle of chasing increased wages by rising prices and, in turn, pursuing rising prices by increased wages. This cycle continues, and inflation continues, just like the 1970s wage-price spiral in the US. We can also understand it as the cost-push factor of inflation.

Diagram

The diagram given above describes how the process of wage-price spiral inflation occurs in an economy. It shows how the increase in price level consequently leads to higher labor cost due to rise in wages.

When consumers increase their spending on goods, demand automatically rises, driving up their prices. Also, higher wages increase the labor cost of firms, which they pass on to consumers in the form of higher prices to protect their profit.

Causes

There are many significant causes of spiralling of wages and prices in an economy. Let us try to find out what are the situations that lead to it.

The spiral may begin with an external shock like a global rise in oil prices. This raises the workers' expectations of inflation. This expected inflation makes the workers ask for higher salaries from their employers. Thus, the cost of labor increases manifolds. Therefore, the firms are forced to raise their output prices to sustain their profit.
Thus, the general prices of the goods and services in an economy soar. Furthermore, this leads to an increase in inflation. Inflation then leads to a higher cost of living, as shown by the consumer price index (CPI).
If the increase in wages is not commensurate with inflation, the workers' real incomes start to fall rapidly. Subsequently, the country's labor union tries to negotiate with the employers for a better salary structure to cope with the inflation using their strength of unions. Thus, the spiral performs a full circle, and again the cycle begins from here.
Wage-price spiral economics is also likely to happen when higher demand combines with full employment. When firms are operating at their full capacity, any further increase in output will require more resources, including labor. As a result, firms will be willing to offer higher wages to workers to hire them, thus triggering the wage-price cycle.
Sometimes the labor unions are strong enough to influence the management to raise wages. Their significant bargaining power may lead to increase in wages which in turn is passed on to consumers through rise in prices.
If the economy is flourishing industrially, then there is a possibility of increase in employment facility, this raising the purchasing power of the consumers due to higher disposable income. This again contributes to the spiral of wages and prices.
Any expansionary monetary policy imp;emented by the government may lead to spiralling prices, which in turn develop wage increase, and eventually higher inflation.
Sometimes countries suffer from imported inflation, where, due to high imports, the high prices of imported goods increase the price in domestic market.

Examples

Let us better understand the wage-price spiral economics using the examples below.

Example #1

In the period from 1970to the 1980s, the trade unions in the UK had tremendous bargaining power with the companies. Moreover, the period also saw a rise in oil prices due to the OPEC countries. Therefore, the oil prices led to cost-push inflation in this period leading to higher cost of consumables.

However, the trade unions applied their united bargaining power and demanded an increase in the workers' salaries incommensurate with the cost-push inflation. Thus, the firms had to increase the prices of their goods to give wage hikes to the workers, which led to inflation. Therefore, the Bank of England raised the interest rate to control the spiral in wage prices.

A similar scenario is playing out in the UK of late. With the inflation rate expected to touch 7.25% in April and the unemployment rate at an all-time low, the ground is ripe for the wage-price spiral. However, with extra capacity within the existing workforce and labor market flexibility, inflation is not expected to drive up the wages as per the sources.

Example #2

In the 1970s, the American economy experienced a spiral in wage-price caused by the high oil prices of OPEC in the 1970s. The rising oil prices led to inflation it is the US economy. In addition, the increasing oil prices resulted in wage hike demand by the unions. Strong unions were able to negotiate higher wages, ensuing a wage-price cycle.

It was common for companies to raise the prices to accommodate increased wages in the US. Thus, with a 7-10% rise in labor costs every year during the 1970s, wage-price chasing prevailed in the US. The wage-price cycle led to widespread inflation.

Thus, the Federal Reserve stepped in and increased interest rates to curb the supply of money into the markets and check inflation. Unfortunately, although it successfully stopped the spiral, it led the economy to a recession in the 1980s.

The latest report on the American economy indicates that it may be on the verge of a wage-price cycle as inflation and wages are rising at their highest rates. However, reasons exist to doubt its occurrence in the near future. Productivity growth, weakened trade unions, and low inflation expectations are likely to keep wages and prices in check.

Thus, the two examples given above clearly explains how the spiralling process occurs through some real examples, the extent to which it affects the economy and how the government tries to bring the situation under control by implementing various policies or through negotiations.

How To Stop?

The wage-price spiral economics results in higher inflation and must be nipped in the bud. There are several methods of stopping it.

Productivity growth - Inflation occurs when the demand outpaces supply. With an increase in production, the supply matches the demand keeping the prices in check. With falling cost-push inflation, the inflation expectations reduce; thereby, demand for higher wages declines, breaking the spiral.
Central bank's adjustment of interest rates and monetary policies - In order to check inflation, governments act through central banks. The central banks intervene by adjusting interest rates and controlling the money supply through monetary policies. Higher interest rates act as a disincentive for spending. This reduces demand, pulling the prices down. Lower prices keep the wages remain static, thereby busting the spiral.‌‌

Frequently Asked Questions (FAQs)

What is the wage-price spiral?

The wage-price spiral means that an increase in the worker's salary will lead to a price rise of goods and vice versa in a spiral manner. Thus, the spiral may lead to inflation in the economy.

What causes a wage-price spiral?

The expectation of inflation in workers' minds leads to the demand for higher raises in their salaries. Higher salary pay-outs add to the company's cost forcing it to raise the prices of the commodities to sustain profits. Thus, a spiral in wage prices begins. Sometimes, external forces like a temporary rise in oil prices may also cause a wage-price spiral in the economy.

What can a wage-price spiral lead to?

The spiral in wage price leads to an increase in labor costs, price rise of commodities, rise in wages, and ultimately inflation. Whenever there is a rise in wages due to the pressure of cost and demand upon the labor market, inflation results from the pressure impacting the goods markets. Unchecked inflation may reduce the purchasing power of currency and adversely affect the economy.