Answer to Question #128384 in Macroeconomics for Naafu Peter

Question

Q1. Critically analyse how an increase in wages can lead to cost-push inflation as well as demand-pull inflation

Answer 1

According to Keynesians, households (people) perform a dual role in an economy; they are the suppliers of labour as well as the demanders of goods and services they assist in producing. As a result, labour constitutes a significant proportion of the firm's cost of production, and the suppliers of labour contribute to aggregate demand in the macroeconomy through consumption expenditure. Thus, an increase in wages has a potential of fueling both cost-push and demand-pull inflationary pressures.

Firstly, an increase in wages significantly increase the cost of production since labour forms a great proportion of the firm's factors of production. This increase in cost of production reduces the profitability of goods and services, and hence the incentive and signalling functions of the price mechanism comes into effect; the aggregate supply curve swivels upwards and outwards, signalling a decline in aggregate supply. The eventuality is the perpetual upward thrust on prices translating into cost-push inflation.

However, an increase in wages per se is not inflationary. An increase in wages will cause cost push inflation if labour productivity does not increase at the same rate. An increase in productivity at a rate equal to or higher than the rate of increase in wages will offset the increase in wages and could result in a decrease in the general price levels, instead, for aggregate supply will increase. Thus, cost-push inflation will emanate from an increase in wages at a rate higher than the increase in labour productivity. In most cases, wage-price spirals become unavoidable and the general price levels sky-rockets.

Secondly, an increase in wages will, ceteris paribus, increase consumer's disposable income. The increase in disposable income escalates consumption expenditure which is a component of aggregate demand. As a result, the aggregate demand will increase and hence the general price levels: demand-pull inflation.

However, the increase in wages per se will not fuel demand-pull inflation; the rate of increase in real gross domestic product( real GDP) matters. There is no demand-pull inflation if the rate of increase in real GDP keeps pace or outpaces the rate of increase in aggregate demand as is the case when the economy is below full employment equilibrium. Thus, an increase in wages will only cause demand-pull inflation when the economy is in full employment equilibrium, at which point aggregate supply is perfectly inelastic and cannot respond to the increase in aggregate demand, translating into shortages and hence an upward thrust on the general price level as the price mechanism responds through the rationing function.