Wage-price spiral

A wage-price spiral is an economic phenomenon where an increase in wages leads to a corresponding increase in prices, leading to a further increase in wages to compensate for the increased prices. This creates a vicious cycle of inflation. This can happen when workers demand higher wages to cover the increased cost of living, and employers raise prices to cover the increased labor costs, leading to further wage demands and price increases. The spiral can be inflationary because it can cause a persistent increase in the overall level of prices in an economy.

Interest rate adjustments by a central bank can halt a wage-price spiral by slowing down economic activity and reducing inflationary pressures. When interest rates increase, borrowing becomes more expensive, discouraging spending and reducing demand for goods and services. This can slow down economic growth and reduce upward pressure on wages and prices.

Higher interest rates also reduce consumer and business spending, lowering the demand for goods and services, and reducing the incentive for firms to raise prices. With lower demand, firms have less pricing power, making it harder for them to pass on wage increases to consumers in the form of higher prices.

In this way, interest rate adjustments by the central bank can help to break the wage-price spiral by reducing inflationary pressures and stabilizing prices. However, it's important to note that the effects of interest rate adjustments on the economy can take time to materialize and the central bank must carefully consider the impact on employment and economic growth when making adjustments.

Some central banks also have the power to change the amount of reserves that banks are required to hold, affecting the money supply and influencing inflation. Reserve requirements refer to the portion of deposits that commercial banks must hold in reserve, either in cash or with the central bank.

When the central bank or government regulator increases reserve requirements, it reduces the amount of funds that commercial banks have available for lending, decreasing the money supply and the amount of funds available for spending. This can reduce economic activity, slow down spending, and reduce inflationary pressures.

Conversely, if the central bank decreases reserve requirements, it increases the amount of funds available for lending, increasing the money supply and promoting economic activity. This can lead to increased spending, higher demand for goods and services, and higher inflation.