Monday, June 19, 2017

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What is '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 increases disposable income, thus raising the demand for goods and causing prices to rise. Rising prices cause demand for higher wages, which leads to higher production costs and further upward pressure on prices, creating a conceptual spiral.

BREAKING DOWN 'Wage-Price Spiral'

Wage-price spiral is an economic term that describes how prices increase when wages increase. It's a phenomenon that occasionally occurs when the general prices for goods and services increase, causing workers to demand a wage hike. The wage increase effectively increases general business expenses that are passed on to the consumer in the form of higher prices. It's essentially a loop or cycle that perpetuates itself by consistent prices increases.

The wage-price spiral deals with the causes and consequences of inflation, and it is therefore most popular in 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.

How a Wage-Price Spiral Begins

A wage-price spiral is a simple matter of the effect of supply and demand on aggregate prices. People who make income above their cost of living usually decide on 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, increasing demand. The lift in aggregate demand and the increased wage burden causes businesses to increase the prices of products and services. Even though wages are higher, the increase in prices causes workers to naturally demand even higher wages.

If the higher wages are granted, it will start a spiral where prices subsequently increase, repeating the cycle until wage levels can no longer be supported.

Stopping a Wage-Price Spiral

Governments and economies like to have stable inflation — or price increases. A wage-price spiral often makes inflation increase 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, by way of the interest rate, reserve requirements or open market operations, to curb the wage-price spiral.

However, the United States has done this in the past and actually caused a recession. The 1970s was a time of oil price increases by OPEC that resulted in increased domestic inflation. The Fed 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.

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