Monetary Policy - Inflation - Causes
Theory 6 - Wage-price spiral - is inflation spiraling out of control?
It is very easy to muddle demand-pull and cost-push inflation. This potential for muddling is made worse by the fact that the two types can often interact to cause a wage-price spiral.
This is most likely to happen when the economy is nearing its potential, in other words near full employment. When this happens, any increase in demand implies that firms need to expand output to meet the demand. If firms are at or near their full capacity they will seek to attract resources to expand - labour being part of these resources. Any skilled labour is likely to be employed and so firms have to offer more attractive packages to persuade people to move from one job to another thus increasing their costs.
Employees will want to be compensated for the higher prices, as they don't want to see their purchasing power fall. They will then push for higher wages. The higher wages push up costs again, and so the firms put up prices again. If prices go up again, then people will ....... and so it goes on. The higher wages push up prices, which in turn push up wages, which in turn push up prices, which in turn .....
A wage-price spiral can be very difficult to get rid of, as people quickly build the increased level of inflation into their expectations. That is why it is called a spiral as inflation spirals up and up fuelled by increased wages.