The ‘wage-price’ spiral is a symptom of Inflation, not the cause

In June, the Bureau of Labor Statistics (BLS) announced that the Consumer Price Index (CPI) had risen by 8.6 percent in the year to May. This was “the largest 12-month increase since the period ending December 1981.” What is causing this?

One common explanation is higher wages which, it is said, drive what is known as the “wage-price” spiral. CBS News recently carried a discussion between reporter Brook Silva-Braga and ‘What’s Your Problem’ podcast host Jacob Goldstein that explained how this works:

Silva-Braga – But of all the supply issues contributing to inflation, none are as important to economists as the supply of workers. Right now for every American looking for a job there are two job openings.

Goldstein – So unemployment is at this historic low now, right? And, sort of weirdly, that’s a big part of the reason inflation is so high.

Silva-Braga – It can be hard to grasp at first, but low unemployment is both good for individuals and sometimes problematic for the economy because it means employers have to outbid each other for the few available workers.

Goldstein – And what shops like this, what lots of businesses have to do, is raise wages, right? And the way they can afford to raise wages is by passing this cost on to you, by raising the prices, and so that’s what’s happening across the economy right now.

With all due respect to Goldstein and Silva-Braga, this isn’t what is happening.

It is true that in a tight labor market businesses have to compete keenly for workers. But it is not true that they can do so simply by offering higher wages and passing the cost onto consumers. If a restaurant, say, raises its prices to cover higher wages, it may lose customers. And if this business can raise prices without losing customers the question has to be asked: Why didn’t it do so before?

The phenomenon we are faced with is one where the restaurant can raise prices without losing customers, and that happens because the customers have more money to spend. Here we approach the real cause of inflation: the creation of extra money.

With a fixed supply of money in the economy, the rise of one price will cause consumers to scale back consumption of either that good or some other good (or a mix of both). Whichever it is, the quantity demanded will simply fall until equilibrium is achieved: there is no spiral.

If the amount of money the consumer has to spend increases, on the other hand, they can pay the higher price without cutting back elsewhere. But the key is where they got that extra money from. If the total supply of money in the economy is fixed, then someone else’s holdings of money must have fallen and, with it, their capacity to spend. Their demand will decrease, which means there is no general increase in prices. Once again, there is no spiral.

But if the amount of money the consumer has to spend increases and so does everybody else’s—or many people’s, at any rate—then their increase in spending does not correspond with an offsetting decrease somewhere else. Indeed, everyone can increase spending together. Now we have a spiral.

The essential fact of the matter is that any “wage-price” spiral is a consequence, not a cause of inflation. The cause is the increase in the supply of money.

As Milton Friedman famously said: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

This article originally appeared at the Foundation for Economic Education