Wage-price Spiral: How it Affects the Economy

by | Feb 9, 2023

Inflation is something that can affect all parts of the global economy. Therefore, it makes sense for investors to have a comprehensive understanding of how inflation works and its effects on businesses, individuals, and the overall financial system. Investors should understand the various causes of inflation in order to better prepare for future inflation trends as well as reacting to current inflationary conditions. One theory of how inflation could be caused is the wage-price spiral. 

Wage-price spiral basics 

A macroeconomic theory, the wage-price spiral, attempts to explain how the relationship between wages and prices can cause inflation in the overall economy. This theory asserts that increasing wages results in consumers having more money to spend which then causes demand for goods and services to rise. This results in increasing prices which prompts more demand for higher wages, resulting in higher production costs and then again increases prices for consumers in a cyclical economic phenomenon. 

Spiraling out of control 

The problem with inflation caused by a wage-price cycle is the self-perpetuating nature of the phenomenon which can result in inflation becoming out of control which can cause serious damage to investor portfolios and the quality of life of everyday people. This may start when workers receive a wage increase which puts more money in their pockets. As a result, consumer demand for goods and services increases which puts upward pressure on prices. Higher prices can translate into steeper costs of living which prompts workers to demand even higher wages. The perpetual cycle can easily become unmanageable. 

How to deal with a wage-price spiral 

Governments are always wary of the detrimental effects of a potential wage-price spiral may result in what is known as cost-push inflation. This causes many everyday people to suffer and experience significant financial hardship. Therefore, governments will take action to mitigate this type of inflation before the self-perpetuating wage-price spiral becomes uncontrollable. Governments have several options to choose from in order to mitigate inflation from a wage-price spiral. 

For example, the nation’s central bank can tamp down inflation by decreasing consumer demand. The central bank can do this by increasing its benchmark interest rates which may trigger other interest rates in the economy to rise.. This makes borrowing money more costly, ultimately slowing down overall economic activity resulting in a slowdown in inflation. 

On the other hand, a wage-price spiral may not be caused by too much supply of money in the system but instead has more to do with issues of supply chain disruptions. In this case the government can pass legislation aimed at improving supply chain efficiencies. Also, by making trade agreements with other nations the government can lessen constraints on supply of needed products and commodities. 

What can investors do to help hedge against wage-price spiral inflation? 

 Those who want to protect purchasing power may look to investment vehicles that have return potential to exceed the pace of inflation. Consider opportunities to diversify your holdings across assets that may respond differently to market conditions. We encourage you to contact our office so we can help you understand your options for combating inflationary environments.