Do Higher Wages Cause Higher Prices, Or Do Price Rises Cause Wage Rises? Essay, Research Paper
Do higher wages cause higher prices, or do price rises cause wage rises?? What
are the policy implications in either case?Inflation involves
changes in both prices and wages, and can be initially caused by either.? Therefore, in this essay I will look at two
cases of inflation, one which is caused by a change in aggregate demand, and
one which is caused by a change in aggregate supply.? Both of these will have relation to prices and wages.? I will then examine the fiscal and monetary
policy responses available to government in either case.In the first case,
a rise in aggregate demand could lead to inflation.? This kind of inflation is referred to as demand-pull inflation.? An initial increase in the level of aggregate
demand could be caused, for example, by a rise in government spending. This
would cause the aggregate demand schedule to shift to the right, and the
short-run equilibrium point would move upwards and to the right along the
short-run aggregate supply curve.? This
would lead to a rise in prices as well as an expansion in GDP.? However, this would place the economy above
long-run aggregate supply, and therefore producing more than its long-run
potential.? This means that the economy
is operating with unemployment lower than the natural rate, and the ensuing
labour shortages will lead to a rise in wages.At first glance,
there does not seem to be any reason why this should lead to a process of
inflation rather than just a one-off price rise.? The graph below illustrates what might be expected to happen:Real GDP starts at
Y0, with prices at P0.? However, as
aggregate demand shifts outward from AD0 to AD1, real GDP moves to Y1, with an
accompanying price rise from P0 to P1.?
However, unemployment is now above its natural rate and therefore wages
rise.? This increase in wages results in
the short run aggregate supply curve falling, from SRAS0 to SRAS1.? Real GDP falls back to its long run
equilibrium level at Y0, and prices rise again to P2.? However, since the economy is now in equilibrium again there
seems no reason for further inflation.The only way that
this could lead to inflation, rather than a one-off increase in prices, is if
aggregate demand keeps increasing.? This
can only happen if the government allows the quantity of money supplied to
constantly increase.? An example of this
is shown on the graph below.? The money
supply increases, causing a rise in prices and real GDP, but this is quickly
followed by a rise in wages and a scaling-back of production which restores the
economy to equilibrium unemployment with a higher price level.? However, this is again followed by an
increase in the money supply, and therefore aggregate demand, and the cycle continues
to repeat itself.This sort of
inflation clearly involves wages following prices, the ultimate cause being an
expansion of aggregate demand.? This
could be caused by governments overestimating the potential of the economy, and
thus believing that the long run aggregate supply curve lies somewhere to the
right of its actual position.? In that
case, governments might spend more money in order to try to get the economy
back to its potential level.? However,
since they would in fact be attempting to cause the economy to operate above
its potential level all that would result would be inflation.Alternatively, the
continuous expansion of the money supply which is a necessary condition of this
sort of inflation could be caused by political problems associated with a high
natural rate of unemployment.? It is
quite possible that the rate of unemployment which is natural to the economy
will be too high to be politically acceptable, in which case the government
might make efforts to increase demand, and therefore employment, for short run
political gain.? Alternatively, the
government might consider low unemployment such a high priority that they are
prepared to allow the continuous inflation as the price of maintaining such a
level of unemployment.The model
constructed above suggests that this sort of demand management is not the best
way to either reduce unemployment or control inflation.? Governments could try to make this policy
work by placing a cap on prices and wages and preventing them from rising even
when real GDP was expanding through an increase in the money supply.? However, this sort of policy is difficult to
undertake in practice, because it is likely to be very unpopular
politically.? Furthermore, direct
interference in the level of prices by government could lead to upsets in other
parts of the macro economy.? It
therefore seems reasonable to suggest that tight monetary policy is the best
way to overcome this sort of inflation, since if the money supply is not
increasing there will be a return to equilibrium at some point.? If equilibrium unemployment is too high to
be politically acceptable, perhaps it is necessary to more closely examine the
causes of this unemployment.? This may
well entail structural changes to the economy as a whole.Having seen that
in demand-pull inflation wage levels follow price levels, we can see that in cost-push
inflation the reverse is true, with changes in the levels of wages causing
changes in the levels of prices.? This
sort of inflation occurs when something pushes the short run aggregate supply
curve to the left.? This might be caused
by rising wages, or rises in the costs of raw materials.? Either way, firms are forced to cut back
their production because of the rising costs, and so we see a reduction in
supply.? The equilibrium points moves
upward and to the left, as shown on the graph below, with the result that the
economy experiences stagflation – a contraction accompanied by a rise in
prices.Again, without
something further happening this would not result in inflation, but just a one
off rise in price, from P0 to P1.?
However, when a shock like this occurs governments often feel
constrained by public opinion to take action to restore the economy to full
employment and restore the Y0 level of real GDP.? In order to do this, they are likely to attempt to attempt to
increase the aggregate demand by increasing the money supply.? If they do this, then the economy will be
restored to long run equilibrium as shown below. Although this has
seen a further rise in prices, it is still not sufficient of itself to cause
inflation, because it has restored the economy to equilibrium. However, by
accommodating the change in supply government has made it apparent to those
responsible for the original change in supply – either the producers of raw
materials or trade unions – that their tactics have been successful, and they
may well repeat their actions.? In this
case, inflation could ensue.Faced with this
type of shock, the government is faced with a dilemma.? Either they accept the new, lower rate of
employment, or they step in to act, with the risk that they will cause a spiral
of inflation by doing so.? It is clear,
however, that cost-push inflation is very unlikely without government
action.? If unions continued to drive
for higher wages, they will see decreased output and therefore more
unemployment.? Higher unemployment
destroys the bargaining positions of the Unions, and they will be unable to
continue their wage demands.? Likewise,
producers of raw materials will begin to feel the contraction of their market
as firms respond to higher prices by reducing output, and so are unlikely to
continue their price rises unless government accommodates the shocks they are
causing.In conclusion,
whether prices are driving up wages by demand-pull inflation or wages are
driving up prices by cost-push inflation, the most sensible course of action
for governments appears to be to maintain strict control over the money
supply.? Perhaps sometimes it might be
preferable to relax monetary control slightly in order to increase employment,
but the price for this will always be inflation.
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