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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