Wage-Price Spiral: What It Is and How It’s Controlled

What Is the Wage-Price Spiral?

The wage-price spiral is a macroeconomic theory that explains the cause-and-effect relationship between rising wages and prices, or inflation. That is, as rising wages increase disposable income, demand for goods rises, triggering prices for goods to move higher.

Rising prices then increase demand for higher wages, which leads to higher production costs and further upward pressure on prices, creating a conceptual spiral.

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 of consistent price increases is created.

The wage-price spiral reflects the causes and consequences of inflation, and it is, therefore, characteristic of Keynesian economic theory.

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 living decide upon an allocation of savings and consumer spending. As wages increase, so does a consumer's propensity to both save and consume.

For example, if the minimum wage increases, many consumers within the economy will purchase more products, 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 may be higher, these higher prices cause workers to demand higher salaries again. If higher wages are granted, a spiral where prices increase may occur. This cycle can repeat until higher wage levels can no longer be supported.

Stopping a Wage-Price Spiral

A wage-price spiral often pushes inflation to a level that is not ideal. The U.S. Federal Reserve aims to sustain an inflation rate of 2%, which it deems appropriate to maintain maximum employment and price stability.

Governments tackle an inflationary environment through the actions of a central bank, such as the Fed. Thus, when U.S. inflation moves higher that 2%, the Fed takes steps to bring it back under control.

Monetary Policy

The Fed can use monetary policy tools such as administered interest rates, reserve requirements, and open-market operations to curb inflation and the wage-price spiral.

However, this can sometimes trigger a recession. For example, 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. This stopped the spiral in the short term but led to a recession in the early 1980s.

Inflation Targeting

Inflation targeting is a monetary policy strategy whereby the central bank sets a target inflation rate (as mentioned above) for a period of time 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.

They concluded that governments should use discretion based on the circumstances when deciding to use inflation targeting as a tool to control the economy.

The Bottom Line

The wage-price spiral is a perpetual cycle where rising wages create rising prices and vice versa. The Fed uses monetary policy tools to target resulting inflation and curb the wage-price spiral.