# Puzzled by proposed inflation mechanisms

There are some explanations for long term inflation that completely baffle me in that they seem so deeply flawed that I wonder how come they are taken seriously.

So take for example the idea of a "wage price spiral". The idea is (very roughly) that workers demand big wage increases so the companies that employ the workers have to put their prices up to maintain profitability but this then induces workers to demand even higher wages - repeat ad infinitum. The problem is that unless there is an accompanying increase in the money supply (and why would there be) then there is no way for this to continue. The rate of flow of money being used to purchase goods would be required to grow continuously. This can only be achieved through an increase in money velocity. This might happen for relatively short periods but decade after decade? This makes no sense.

I could make a similar argument about the idea that inflation expectations drive inflation. Without ever increasing velocity this cannot work.

Am I missing something?

AFAICT The only inflation theory that does not suffer from this flaw is money supply driven inflation. It's relatively easy to see how the money supply can grow indefinitely.

EDIT: I guess my criticism of the wage price spiral and inflation expectations could be invalid on several grounds:

1. I have missed something in my logic and the criticism is simply invalid.
2. Wage price spiral and inflation expectations only account for short term fluctuations and cannot (or are not intended to) explain long term inflation.... come to think of it, without a permanent rise in the money supply or a permanent increase in money velocity then the temporary rise in inflation must be followed by a fall back to the original price level.
3. Wage price spiral and inflation expectations can work in the very long term because both of them are things which actually cause the money supply to grow, thereby avoiding the need for ever increasing velocity.
4. Something else I haven't thought of.
• "there is an accompanying increase in the money supply (and why would there be)" ...why wouldn't there be? Jul 4 at 16:13
• What actually even is your question? You want to understand the mechanisms behind these two results or what?
– 1muflon1
Jul 4 at 16:14
• @1muflon1: My question could be phrased as "how would a proponent of either of these two theories defend themselves against this criticism".
– Mick
Jul 4 at 18:40
• @Giscard: Are you suggesting that a wage price spiral would cause an increase in the money supply? By what mechanism?
– Mick
Jul 4 at 18:44

Inflation Expectations

Inflation expectations affect inflation because people are not myopic and take future into consideration.

For example, if you expect that tomorrow prices will double, and you are having job interview today, you will be negotiating for your salary based on your expectations of future. If everyone expects inflation to be 3% people will start to incorporate that expectation into their economic decision making today.

Prices often follow self-fulfilling prophecies. If everyone expect crude oil to sell for \$100 a barrel tomorrow, then if price today is lower people start to hoard/buy it which pushes the price to \$100 today. People and even fully rational agents of economic models act based on their beliefs about reality and future reality, not necessarily about what the reality is.

In fact even when it comes down to fundamentals, such as money supply, real output etc., in modern economic models it does not just matter what they are today, but it matters far more what people expect them to be in the future (e.g. see discussions of this in Romer Advanced Macroeconomics, or Woodford Interest & Prices). Undergraduate textbooks often abstract from expectations as they are not always easy to model mathematically but once you get to graduate level models you will see expectations everywhere.

There are many rigorous theoretical models which show that inflation expectations matter via various mechanisms (see Friedman (1968), Phelps (1968), Mortensen (1970) and Lucas and Rapping (1969). In addition, these theories were already tested empirically so much that at this point its nearly impossible for a reasonable person to deny the evidence on effect of inflation expectations (see the seminal paper of Carlson and Parkin (1975) and studies cited therein)

Brookings has an nice explainer accessible to laymen for importance of inflation expectations you can read here.

The Wage Price Spiral

This one is bit more controversial reason than inflation expectations since it requires many assumptions on the nature of competition on both labor and goods markets and some specific market rigidities to work, but it certainly can work. The mechanism for this is as follows (Blanchard, 1986):

after an increase in aggregate demand, the process of adjustment of nominal prices and nominal wages results from attempts by workers to maintain or increase their real wage and by firms to maintain or increase their markups of prices over wages. Under continuous price and wage setting, the process of adjustment would be instantaneous; under staggering of price and wage decisions, the adjustment takes time. The more inflexible real wages and markups are to shifts in demand, the higher is the degree of price level inertia, and the longer lasting are the effects of aggregate demand on output.

There is also empirical evidence for Wage Price Spiral, which although not as overwhelming as in the case of inflation expectations, is nonetheless quite convincing (e.g. see Kandil 2007).

• So you've explained the two theories in detail and described evidence in support of them but you have omitted to mention how they get round my specific criticism. I.e. how can either one of them work in the long term unless either the money supply increases or the velocity increases?
– Mick
Jul 5 at 7:33
• @Mick but that’s not valid criticism. 1. In the case of wage-price spiral, as quote from Blanchard explains, this is result of staggered adjustment. So by definition wage-price spiral is short run transitory phenomenon, you will observe as AS-AD are reaching new stable equilibrium. 2. As explained in the first part what matters is people’s beliefs about quantities and future expectations. Actually it does not matter what money supply is at all but what people believe it to be. If I have empty sack but I convince people it’s full of money and people are willing to
– 1muflon1
Jul 5 at 9:09
• Let me buy items with the sack as if the sack contained 1000 USD then just that belief itself expands money supply by 1000 USD regardless of what the true quantity of money supply is. When it comes to expectations they are just beliefs about future, people plan ahead. It does not matter what money supply or output or velocity of money today is it matters what people believe it to be tomorrow. If people believe tomorrow output will fall which will ceteris paribus also lead to inflation (money supply is not only thing that affects inflation) then people will hoard output already today.
– 1muflon1
Jul 5 at 9:13
• Every day people form new expectations about the future and people never stop forming expectations until they die, or I don’t know if there are some medical conditions that could prevent a person from planning, so expectations affect inflation always it’s just another channel you have to consider. In fact even Friedman claimed that MV=PY holds in expectations. So more appropriate way of expressing that would be that E[MV]=E[PY]
– 1muflon1
Jul 5 at 9:16
• See edit to OP. Is your claim that answer number 2 applies?
– Mick
Jul 5 at 11:48

I do agree expectations play a big part of that, if theoritically wage-price spiral causes inflation.

But possibly maybe this scenario may somehow fit for wage-price spiral inflation to last in the long run,

Suppose There is a Shortage of Supply of a Key Commodity or Commodities, or fundamental essential Goods/Services for a society, that will last from the present time to the Long Run. The Prices of those Commodities or Goods/Services will increase by Large Amounts. Since the Prices of those Commodities or Goods/Services will increase, Workers will demand Higher Wages from Firms. Here we have 2 things, 1 Higher Wages, more buying power, but then Less Supply of Commodities or Goods/Services, which will increase prices, which will cause inflation, which in effect will decrease the buying power of the new wages given to the Workers.

So in this scenario, the Tip of the Cause is the Shortage of Supply of Goods, and not a manipulation of Money Supply.