Do Higher Wages Cause Higher Prices Or

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

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