Do higher wage cause higher prices, or do price rises cause wage rises

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.