The economy has been a worry for many people lately. Much of this has to do with rising inflation and the negative effects it is having on everyday people. This has made many people curious about the economic theories which attempt to explain what causes inflation. One economic theory offering an explanation of what causes runaway inflation in certain instances is the wage-price spiral theory. 

What is the wage-price spiral? 

This macroeconomic theory offers a view on the relationship between rising wages and increasing prices. Basically, this theory asserts higher wages result in increased disposable income for consumers which then increases demand for goods and services. This increase in demand results in higher prices. Also, the higher labor costs translate to steeper costs of production which is passed on to consumers in upward pressure on retail prices. 

Perpetual loop 

The problem with a wage-price spiral is it can quickly get out of control since the inflationary effects are like a perpetual loop in a way. Workers who obtain a wage increase will be more ready to spend on goods and services. This increase in demand will result in higher prices which ultimately increases the cost of living. In response to the cost of living rising too fast, workers will demand higher wages to compensate which of course feeds into higher costs of production, which is also passed onto consumers, prompting workers to ask for even higher wage increases. 

Mitigating the wage-price spiral 

Inflation from a wage-price spiral, also known as cost-push inflation, can be highly detrimental to an economy. It can cause everyday working people to suffer which is why governments aim to curb this type of inflationary perpetual cycle to prevent it from spiraling out of control. The government has several different options for actions to take to combat wage-price spiral inflation. 

One option is to leverage monetary policy through the country’s central bank. This can mean raising interest rates or reducing money supply in order to decrease demand in the economy which will control upward pressure on wages. 

However, if the cause of a wage-price spiral has something to do with a constrained supply chain, the government can take action to improve supply chain infrastructure through legislation. The government can also enter into trade agreements with other countries to relieve supply constraints on commodities and products that are in need. 

For example, if a country’s main supplier of oil is suddenly attacked by a neighboring country, the flow of oil may be disrupted. This will cause higher prices for oil-related products, such as gasoline needed to fill up your vehicle’s gas tank. The resultant increase in cost of living may cause workers to demand higher pay which further exacerbates inflation and starts the perpetual cycle of the wage-price spiral. The government can alleviate some of this by agreeing to a trade deal with another oil-producing country which may make up for the diminished oil supply. 

How do investors mitigate a wage-price spiral? 

In the midst of inflation resulting from the wage-price spiral it is necessary for investors to take action in order to protect their investment portfolios. There are various types of investment assets which tend to be inflation-resistant or can act as hedges against rising inflation. Your financial advisor can provide you with some investment options to protect against inflation.