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In macroeconomics, the price/wage spiral (also called the wage/price spiral) represents a vicious circle process in which different sides of the wage bargain try to keep up with inflation to protect real incomes. Thus, this process is one possible result of inflation. It can start either due to high aggregate demand combined with near full employment or due to supply shocks, such as an oil price hike. There are two separate elements of this spiral that coexist and interact:
- Business owners raise prices to protect profit margins from rising costs, including nominal wage costs, and to keep the real value of profit margins from falling.
- Wage-earners try to push their nominal after-tax wages upward to catch up with rising prices, to prevent real wages from falling. To maintain purchasing power equal to the rising costs reflected by a consumer price index (CPI), a taxable salary must increase faster than the CPI itself to result in an after-tax wage increase comparable to the increased cost of goods and services - unless tax brackets are indexed.
So "wages chase prices and prices chase wages," persisting even in the face of a (mild) recession. This price/wage spiral interacts with inflationary expectations to produce long-lived inflationary process. Some argue that incomes policies or a severe recession is needed to stop the spiral.
The first element of the price/wage spiral does not apply if markets are relatively competitive.
The spiral is also weakened if labor productivity rises at a quick rate. Rising labor productivity (the amount workers produce per hour) compensates employers for higher wages costs while allowing employees to receive rising real wages, while allowing the company's margin to stay the same.
It is possible that if there is an economic boom, and the money supply does not expand, that the "price wage spiral" would not occur. A company, after all, does not attempt to "protect profit margins", it tries to maximize profits. By the same token, laborers do not "try to catch up with rising prices", they try to maximize their earnings. In an economic boom, the demand for labor would increase. When unemployment gets lower, wages would increase as employers tried to lure workers away from other businesses, regardless of unionization.
Workers would be better paid, and the assumption is that they would consume more. But they would also produce more output, which would tend to depress prices for goods. The loser, in this scenario, would be profits. Companies would be unable to raise prices, as competition for sales would prohibit it. They would be unable to cut wages, as competition for workers would prohibit it. Therefore, their profits would shrink. This would reduce the amounts they were willing to pay for capital goods, and tend to reduce demand for labor in those industries which primarily produce such goods. Thus, high economic growth with a stable money supply would lead to high wages, low profits, more resources allocated to production of consumer goods, and fewer resources allocated to production of producer goods. This should be a self-liquidating phenomena.
Some economists claim that the reason that high economic growth and inflation are often observed together is that when the government creates inflation by printing fiat money, the inflation tricks capitalists into increasing production, which created the illusion of an economic boom. The "spiral" of increasing prices and wages, however, can only continue as long as the government continues to intervene in the economy by inflating the money supply.
As Henry Hazlitt argues: "If it were not preceded, accompanied, or quickly followed by an increase in the supply of money, an increase in wages above the "equilibrium level" would not cause inflation; it would merely cause unemployment. And an increase in prices without an increase of cash in people's pockets would merely cause a falling off in sales. Wage and price rises, in brief, are usually a consequence of inflation. They can cause it only to the extent that they force an increase in the money supply."
- "Theory 6 - Wage-price spiral - is inflation spiraling out of control?", Biz/ed
- Henry Hazlitt. "What You Should Know About Inflation", Mises Institute, referenced 2009-06-07.