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, but this is highly unlikely. The Federal Reserve is in charge of the money supply and will expand only when the Federal Reserve Board of Governors decides it should. To assume that the price wage spiral would not occur is an extreme fallacy because of the economic rule of scarcity. There is only so much money supply. However, a company, after all, does not attempt to protect profit margins, but it tries to maximize profits.
However, this comes at a fallacy. The profit motive is in effect, of course, however, the problem is catching to the efficient area of profitability. Thus, if there is a demand to increase wages, companies could grant it and face higher prices on consumersm because of marginal costs being higher than marginal benefit or lay off workers if the marginal cost increase would be unsustainable. While workers try to maximize earnings as much as possible, laborers must catch up with rising prices in order to protect their purchasing power from being lost.
In an economic boom, the demand for labor would decrease because firms already have enough workers in their business, unusually close to or full employment. When unemployment gets lower, wages would increase as employers tried to lure workers away from other businesses, regardless of unionization. However, there is only a certain extent where extremely low unemployment will be sustainable. In the short run, unemployment decreases as output increases, but inflation occurs because there are many workers, so businesses must cut back from the area of economic loss to obtain economic profit or accounting profit. In the long run, the low unemployment rate may not be sustained because there will always be frictional and structural unemployment, which is why countries usually strive for a 5 % unemployment rate, leaving cyclical unemployment at 0 % and structural and frictional unemployment present.
Workers would be better paid, and the assumption is that they would consume more. However, there is a good thought behind this. As nominal wages increase, people's marginal propensity to consume stays the same, but they are able to purchase more things at the same percentage of marginal propensity. Businesses notice the increase of profit and by the profit incentive and are encouraged to increase prices. Nominal wages increased, but real wages have stagnated. Back to the assumption, they would also produce more output, which would tend to depress prices for goods. There is a fallacy behind the thinking. The Law of Diminishing Marginal Returns states that only a certain amount of workers can produce only so much of a product. To increase output past the certain level would have to be a change in technology.
Companies would then 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. However, many businesses have an alternative solution in this situation by decreasing the amount of workers because their marginal cost exceeds the marginal benefit. As stated before, the business's goal is to maximize profits, the business would have to cut down on unskilled workers because they are more elastic, or more susceptible to unemployment because they have been trained less than those who are skilled workers.
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 fallacy behind this is that the Federal Reserve works alongside with the United States Mint to print money. The government is given the task only to order the increase or decrease of the money supply. Inflation does not incur businesses to increase production, because the money supply affects only aggregate demand.
As Henry Hazlitt argue, "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.