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

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

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 explaining the relationship between rising wages and prices, or inflation. Rising wages increase disposable income and demand for goods, triggering higher prices.

Rising prices increase demand for higher wages, leading to higher production costs and further upward pressure on prices.

Key Takeaways:

– The wage-price spiral describes a perpetual cycle where rising wages create rising prices and vice versa.

– Central banks use monetary policy to curb the wage-price spiral.

– Inflation targeting is a policy to achieve and sustain a set interest rate.

Inflation

The wage-price spiral describes price increases resulting from higher wages. When workers receive a wage hike, they demand more goods and services, causing prices to rise.

The wage increase effectively increases general business expenses passed on to consumers as higher prices. This creates a perpetual cycle of consistent price increases. The wage-price spiral reflects the causes and consequences of inflation and is characteristic of Keynesian economic theory.

A 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. As wages increase, consumers’ propensity to save and consume also increases.

If the minimum wage increases, consumers purchase more products, increasing demand. The rise in aggregate demand and increased wage burden cause businesses to increase prices.

In Jan. 2024, 22 states increased their minimum wage, including Maryland, New Jersey, New York, California, Connecticut, Massachusetts, and Washington.

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Although wages are higher, increasing prices make workers demand higher salaries. This can lead to a spiral where prices increase until wage levels can no longer be supported.

Stopping a Wage-Price Spiral

A wage-price spiral often leads to higher inflation. The Federal Reserve aims to sustain a 2% inflation rate and uses monetary policy to curb the wage-price spiral.

The United States has used monetary policy to control inflation, but it has sometimes triggered a recession. In the 1970s, increased oil prices by OPEC resulted in domestic inflation. The Federal Reserve raised interest rates to control inflation, stopping the spiral in the short term but causing a recession in the early 1980s.

What Is Monetary Policy?

Monetary policy is a set of tools a central bank has to promote economic growth by controlling the supply of money available. The Federal Reserve influences the supply through open market operations, buying and selling financial securities to ease or tighten monetary policy. It can also adjust interest rates to discourage or inspire borrowing and spending.

What Is the Difference Between the U.S. Treasury and the Federal Reserve?

The U.S. Treasury manages the money coming into and out of the government, while the Federal Reserve manages the supply of money in circulation. The Treasury handles federal spending, tax revenues, budget distribution, and debt issuance. The Federal Reserve is the central banking system overseeing 12 regional Federal Reserve Banks.

What Is Inflation Targeting?

Inflation targeting is a policy that adjusts monetary policy to achieve a specified annual inflation rate. It aims to maintain price stability by controlling inflation, which is believed to contribute to long-term economic growth.

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The Bottom Line

The wage-price spiral is a perpetual cycle where rising wages create rising prices and vice versa. Central banks use monetary policy to curb the wage-price spiral.

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