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 cause-and-effect relationship between rising wages and prices, or inflation. 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 select 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 rise in aggregate demand and the increased wage burden cause businesses to increase the prices of products and services.

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 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. To target inflation, central banks use monetary policy, the interest rate, reserve requirements, and open market operations to curb the wage-price spiral.