Higher Wages and Higher Prices
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 labor
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:
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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...
... middle of paper ...
...creased 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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