Figure 4.15 is a two-panel diagram that illustrates the concept of demand-pull inflation. The economy starts at an initial supply-side equilibrium (Point A) with stable inflation. A rise in aggregate demand then pushes the economy along the Phillips curve to a point of higher inflation, demonstrating the mechanism of demand-pull inflation. The diagram shows the initial equilibrium in the WS-PS model (top panel) and the corresponding point on the Phillips curve (bottom panel), which serves as the starting point for the demand-pull inflationary process.

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The wage-price spiral is a self-perpetuating cycle of accelerating inflation that occurs when a positive bargaining gap persists, for instance, when employment remains at a level higher than the new supply-side equilibrium following a shock. The process begins when an initial wage increase leads firms to raise prices to protect their profit margins. This price increase erodes workers' real wages, prompting them to demand even higher nominal wages in the next period to compensate for both the new, higher expected inflation and the ongoing bargaining gap. This cycle of wages and prices chasing each other, fueled by continually rising inflation expectations, causes the Phillips curve to shift upward each period, resulting in an ever-increasing rate of inflation.

The Accelerating Wage-Price Spiral

Demand-pull inflation is a type of inflation that occurs when a rise in aggregate demand leads to a movement along a given Phillips curve to a point of higher inflation. This process is modeled in the multiplier framework as a shift in the aggregate demand (AD) curve. The persistence of this inflation, and whether it evolves into a wage-price spiral, depends on how inflation expectations are formed.

Demand-Pull Inflation

To cite the ebook, use The CORE Econ Team 2023 The Economy 2.0: Macroeconomics Open access e-text https://core-econ.org/the-economy/.

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CORE Econ - The Economy 2.0: Macroeconomics

Figure 4.13 presents a table that contrasts the inflation rate over a three-year span under two distinct unemployment scenarios: one at the equilibrium level of 6% and another at a lower level of 4%. The table's 'Expected inflation' column demonstrates forward-looking behavior, specifically adaptive expectations, where the expected inflation for the upcoming year is set to the actual inflation rate of the previous year. This dataset allows for a direct comparison of how different levels of unemployment affect the inflationary process over time, summarizing the dynamics of the wage-price spiral.

Figure 4.13: A Comparison of Inflation Over Three Years at Different Unemployment Levels

A concrete example of the wage-price spiral can be illustrated with a shifting Phillips curve. An economy begins in a stable state (Point A) with 6% unemployment and 3% inflation. Following a boom that reduces unemployment to 4%, the economy moves along the existing Phillips curve to a new point (Point B), where inflation increases to 5%. For the next period, workers and firms adjust their inflation expectations to 5%. This upward revision of expectations causes the entire Phillips curve to shift upwards. Consequently, even with unemployment held at 4%, inflation will rise again, moving the economy to a new point (Point C) on the higher Phillips curve. This sequence demonstrates how low unemployment can trigger a self-perpetuating, year-over-year increase in inflation.

Example of the Wage-Price Spiral: Shifting Phillips Curve

Figure 4.16 is a graph that visually breaks down the components of inflation over a period of seven years (Year 0 to Year 6). The horizontal axis represents time in years, while the vertical axis shows the inflation rate as a percentage from 0 to 11%. The graph plots the paths of three variables: the overall inflation rate, the bargaining gap, and expected inflation (which is assumed to equal the previous year's inflation). Initially, in Year 0, the bargaining gap is zero and inflation is stable at 3%. The diagram then illustrates how a persistent bargaining gap, created by sustained low unemployment from Year 1 onwards, combines with rising inflation expectations to drive a continuous increase in the overall inflation rate period after period. This visualization clarifies the distinct contributions of the bargaining gap and expected inflation to the wage-price spiral, while the real wage remains constant on the price-setting curve.

Figure 4.16: The Path of Inflation Over Time with a Persistent Bargaining Gap

When actual inflation outpaces expected inflation (e.g., 5% actual vs. 3% expected), workers' real wages are reduced by the difference. This outcome creates a conflict of interest: firm owners are satisfied with the higher prices they can charge, but workers are dissatisfied with their diminished purchasing power. This dissatisfaction is a key driver for the next round of wage negotiations in a wage-price spiral.

Real Wage Reduction and Conflicting Interests from Unexpected Inflation

Figure 4.24 depicts the effects of an oil shock, a type of cost-push inflation. The shock causes the price-setting (PS) curve to shift downward, creating a 2% bargaining gap at the initial employment level. This gap immediately pushes inflation up from 3% to 5%. As inflation expectations adjust to this higher rate, the Phillips curve shifts upward annually, illustrating how a cost-push shock can lead to a continuous, year-over-year increase in inflation, or a wage-price spiral.

Figure 4.24: Illustration of a Cost-Push Inflationary Spiral from an Oil Shock

Figure 4.15: Illustration of Demand-Pull Inflation

Within the WS-PS model, the inflation rate is the sum of two distinct components: expected inflation and the bargaining gap. Expected inflation sets a baseline for wage and price increases. The bargaining gap then adds to this baseline depending on the level of employment relative to equilibrium. For instance, if expected inflation is 4% and there is a positive bargaining gap, the total nominal wage increase demanded, and thus the resulting inflation, will be 4% plus the percentage value of the bargaining gap.

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