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More than once, I have heard on the news how the US Federal Reserve would raise interest rates to counter the risk of inflation, even when they indicate that the potential inflation would be caused by "wage pressure".

I can understand why the wealthy disapprove of inflation -- it causes the value of their wealth to decrease -- but for the poor, this is not a significant concern. And if (for example) the price of products are 50% due to labor, doubling the salary of that labor would only increase their cost by 50%, while the workers who were paid that salary could buy twice as many products. Mathematically speaking, then, I would expect prices to asymptotically approach some new value at a rate of e^(-k/t), not spiral into hyperinflation.

What am I missing here? Is inflation due to wage pressure really a bad thing for the general population, or is this a case of the Federal Reserve bowing to the will of those few who would benefit the most?

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  • $\begingroup$ Can you please explain why differentiating between wage-led inflation and inflation in general is relevant for what you discuss? If it is not, then this is a duplicate. $\endgroup$ – luchonacho Mar 16 '17 at 9:25
  • $\begingroup$ If the wage increases are driven by labor shortages, I would expect the wage benefits to outpace cost increases, per the example I gave. If something else drives up the cost of goods, clearly that's a different story - but I'm interested in the former case. $\endgroup$ – papidave Mar 16 '17 at 22:13
  • $\begingroup$ Possible duplicate of Is zero inflation desirable? $\endgroup$ – luchonacho Mar 17 '17 at 9:47
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    $\begingroup$ If wages don't make all costs for the aggregate productive sector, this means (in a closed economy) that there are other 'pure inputs', e.g. raw materials. So you have to ask yourself how the price of the raw materials will react if the price level of output increases by 50 %. Basically if workers want to increase the real wage, firms want to maintain their margin and raw material owners want to maintain their real rent, the process can not come to an end. $\endgroup$ – Ululo Mar 18 '17 at 15:47
  • $\begingroup$ The concept of "real rent" on raw materials is a new one to me (not being an economist), and may be useful. I have always perceived raw materials as being "available wealth" in the environment, with an associated cost to extract it. $\endgroup$ – papidave Mar 22 '17 at 0:35
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Some of the costs traditionally associated with inflation also continue to hold if the inflation is offset by an increase in average wages:

  • It has distributional consequences. You mention that inflation Hurts the wealthy. But it also hurts the prudent poor who are saving for a rainy day or to get a good start in life.

  • It induces menu costs: the costs firms incur each time they have to change their prices.

  • It induces "shoe leather costs": people must spend time and effort to avoid the effects of inflation—for example, by more actively managing their wealth to minimise their cash holdings. As inflation becomes higher, this might also involve shopping costs for consumers who have to search more because firms' prices are not increasing in sync.

  • It reduces the quality of the price signal. Prices contain important information for those making economic decisions. For example, if it is more costly to mine anthracite than lignite (two forms of coal) then the latter will tend to have a lower price. This low price serves as a signal to the market: "you should switch to using lignite if you can because it is less costly to produce". This is one of the main ways that markets implement allocative efficiency. But if prices are changing quickly due to inflation it can be hard to tell where a discrepancy in prices is a genuine signal about allocative efficiency, and where it is an artifact of inflation.

All of these concerns are only severe for relatively high levels of inflation. Lower levels of inflation are actually thought to be somewhat beneficial for the economy (see, e.g., Why is modest inflation a good thing?). For this reason, the central bank typically does not try to eliminate inflation, but rather tries to keep it from growing too large.

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Wage induced inflation can create inflation spirals, which can lead to hyperinflation. I think everyone agrees hyperinflation is a bad thing for everyone and not just the rich. Furthermore, inflation can be a significant problem for the poor as well.

Such a case of inflation spirals was even threatening post WW2 Germany.

The spiral happens because, if workers demand higher wages that firms cannot pay, then firms may increase prices in order to make up for those losses. This causes inflation, which reduces workers' real wages, so they ask for another wage increase. Firms not in a position to deny or to afford these wages will have to comply and increase prices again. This can go on and on and easily spiral out of control.

In principle it is possible to have higher inflation and higher wage increases. This was the case in Italy before the introduction of the Euro.

However this wage induced inflation also affects non-wage earners, such as those living on welfare benefits, the unemployed living on savings and retirees.

As for whether fiscal stimulus is better put in the hands of the poor, this is a different topic related to fiscal policy and unrelated to inflation (i.e. monetary policy).

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  • $\begingroup$ But why is this different from the case of inflation due to, say, increase in food prices? Provided your assumption that workers react to changes in real wages, then they would still demand higher wages, igniting the spiral, regardless of the initial source of inflation. $\endgroup$ – luchonacho Mar 16 '17 at 10:37
  • $\begingroup$ The spiral doesn't happen because of food prices. If inflation increases because of food prices and workers demand higher wages, which cannot be paid, then these wages lead to more inflation which lead to more wage demands. Regardless of the initial trigger, the spiral channel goes through wages if firms need to offset them with higher prices. A food price increase does not trigger further food price increases without wages being involved. $\endgroup$ – BB King Mar 16 '17 at 10:40
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    $\begingroup$ "then firms will simply increase prices" The firms could have increased their revenue by raising prices all along? How nice of them that they did not do so until now. $\endgroup$ – Giskard Mar 16 '17 at 10:40
  • $\begingroup$ @denesp Firms are always optimizing profits. If wages increase, then they re-optimize in a way that causes them to increase prices. With perfect competition this is clear as prices equal marginal costs and as marginal costs increase due to wages, so will prices. However, this also holds normally for imperfect competition as well. $\endgroup$ – BB King Mar 16 '17 at 10:45
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    $\begingroup$ Fair point, I will remove the "simply". $\endgroup$ – BB King Mar 16 '17 at 12:19

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