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If an employer were to ensure wages kept parity with or outpaced inflation, there's an argument that this would cause runaway inflation. That is, employees would have more capital to play with, so the cost of goods and services would increase to match.

I'm not an economist, but this seems like "lazy thinking" to me:

  • For the sake of argument, let's say this is true. Then a sizeable proportion of employers would need to do this to make a difference. The reality of wage-stagnation suggests that this is generally not done, therefore the effect on inflation -- should a handful of employers pay a not-decreasing-in-real-terms wage -- will be negligible.
  • Why does more liquidity imply more demand and thus higher prices? I can think of at least two other potential scenarios (or a mixture thereof):
    • Goods and services often fall into price tiers based on (perceived) quality. If a person has more money at their disposal, then they could "level up" their lifestyle, rather than buying more of what they used to.
    • People can and do save money. Some things (e.g., home ownership) have become so costly, that the impetus to save -- rather than splurge -- is quite high.

How true is the original assertion? Are my arguments against it solid, and do other/better arguments exist?

(Bonus question: If an employer felt it was "morally imperative" to not drive up inflation, then wouldn't they be duty bound to not increase their prices for the goods/services they provide?)

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  • $\begingroup$ No, by trivial analysis. The equations do not change if gold coins are used, which do not inflate. $\endgroup$
    – Joshua
    Jan 17 at 17:56
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    $\begingroup$ @Joshua inflation is possible with gold money. There are numerous historical examples of gold inflation, in some cases even very high gold inflation like when conquistadors flooded European markets wit gold they pillaged in the new world $\endgroup$
    – 1muflon1
    Jan 18 at 12:44
  • $\begingroup$ I'm in Germany. While the fraction of employees that are under a collective agreement is sinking (long term trend), in 2022 that were still 51 % of all 42e6 employees (2003/04 it were 2/3). The largest union (IG Metall, metal workers + related industries) has 2.2e6 members, likely more employees are under their agreement, but I didn't find numbers. 2nd largest union is verdi (service sector, 2e6 members e.g. covering almost all public sector employees, my guesstimate is that from sector coverage numbers is that there may be 10e6 employees covered by their agreements).... $\endgroup$ Jan 18 at 19:38
  • $\begingroup$ ... Quite different from a single company doing sth or not with the wages of their employees. $\endgroup$ Jan 18 at 19:41

3 Answers 3

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How true is the original assertion?

The original assertion is poorly worded and not generally valid even if we ignore the wording. The assertion (at least a corrected version of it) can be true under certain condition for a limited period of time. However, the mechanism that the explanation talks about is not correct.

First, the statement is poorly worded, since precise language is important if we want be able to make logically sound argument we first have to address that. Capital in economics does not mean money, but actual productive assets, which are accumulated through investment. Hence, taken at face value the argument does not make sense since ceteris paribus more capital increases potential productive capacity of an economy which is deflationary (see discussion in Mankiw Macroeconomics 9th ed Ch 5). I do understand that whoever told you the argument likely meant money by capital but it is important to use clear language, especially since capital and investment will be mentioned further in this answer.

Second, what are we talking about is the wage-price spiral (higher wages leading to higher prices and higher prices to higher wages). Wage-price spirals do exist and can be empirically observed, but they are certainly not inevitable, in fact they are relatively rare and occur only occasionally. A quite comprehensive study of Alvarez et al 2022 could only identify 79 wage-price spiral episodes in sample of 31 countries spanning approximately 30-50 years (different countries have data available for different number of years). Some countries did experience no wage-price spiral and no country experienced more than 6 episodes. The only country that experienced 6 episodes was US which had the longest sample (of approximately 80 years) meaning that in US on average you would expect to see wage-price spiral maybe once every 14 years.

Moreover, all wage-price spirals in Alvarez et al did not lasted more than three months. Hence as you can clearly see these wage-price spirals are rather short lived phenomenon and they 'fizzle' out very quickly. So in real life they are extremely rare and certainly not inevitable.

However, real life wage-price spirals typically occur due to different reasons than employers voluntary committing themselves to offset inflation by higher wages.

Are my arguments against it solid, and do other/better arguments exist?

Some of them are some of them less so. As you correctly mention in your answer, workers could save and invest which expands the productive capacity of an economy and simply results in new macroeconomic equilibrium with both higher wages and lower prices. However, this is only partially correct argument because we know empirically that people do not have 100% propensity to save, and as a result higher income will always result in more consumer spending. Nonetheless, the argument above still could be applicable because deflationary effect of more investment and higher productive capacity can be simply offset by inflationary effect of higher aggregate demand. That is an empirical question.

However, your argument about shifting consumption pattern is very bad argument. CPI is based on a consumption basket of representative household. If people start consuming different items, prices of those items will rise (assuming there is no offsetting factor like increased productive capacity) and they will get higher weight in CPI calculation and thus contribute more to inflation. Hence, this is really non-starter. It could only work on paper if the CPI weights are not being updated, but it would just hide the inflation due to statistics not correctly capturing actual inflation.

As you also correctly point out if single employer does this it would have little to no effect on overall economy because no single employer is simply big enough. For example, in US the largest employer is Walmart, employing about 2.3 million employees. Yet this is less than 1.5% of US labor force. This is unlikely enough to such that Walmart alone could drive wage-price spiral despite Walmart already being outlier in having large workforce. This is probably best of the arguments you mention in your question. I think this is the best argument you can use regarding statement that talks about single employer, no complex economic arguments are necessary.

(Bonus question: If an employer felt it was "morally imperative" to not drive up inflation, then wouldn't they be duty bound to not increase their prices for the goods/services they provide?)

This is a moral not economic question so it does not belong on this site. However, a relevant thing is to note that many business are competitive. A perfectly competitive business already prices its goods equal to marginal costs so if wage costs increase prices have to increase in order to avoid economic loss. In less competitive industries there will be a markup, and business could technically lower the markup before incurring economic losses, but if mark up is 2% and wages increase by 3% then its impossible to lower markup to -1% without incurring economic loss. Business operating with economic loss is not sustainable and will likely shut down eventually.

Now because of Hume's guillotine we cannot get ought's from is's so you could still make a moral argument that employers could be 'duty bound' to not increase prices if they have some anti-inflation moral imperative, but fact is such duty would simply mean eventual shutdown of many businesses. A moral implication of such simple economic fact can be discussed on some site dedicated to moral philosophy.

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  • $\begingroup$ Why would the cost of CPI items rise if people consumed them less (by shifting to a different set of items)? Or are you saying that the CPI items would shift in kind to match real-life consumption? $\endgroup$ Jan 17 at 12:18
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    $\begingroup$ @Xophmeister the latter one CPI is not a simple average but weighted average for example if people stop eating apples then price of apples will be given 0 weight in CPI and won’t affecting inflation at all. If people consume twice as much luxury wine, then the weight of luxury wine increases to reflect this. This is not just statistics but this is also what economic theory says that price level and inflation should measure. Hence consumption shifts do not determine overall inflationary pressure. Of course IRL statistical office recalculates weights only once per 5 years or per year at most so $\endgroup$
    – 1muflon1
    Jan 17 at 13:16
  • $\begingroup$ Sometimes what you said could affect the numbers statistical offices report but the economic concept of inflation (as opposed to just statistical measurement) refers to change in price level of goods that people actually consume $\endgroup$
    – 1muflon1
    Jan 17 at 13:18
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    $\begingroup$ "A perfectly competitive business" - something that exists only on paper, however. Especially in case of large corporations. $\endgroup$
    – rus9384
    Jan 17 at 13:55
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    $\begingroup$ @rus9384 not true empirical studies show that in many countries significant amount of companies (I recall seeing estimates as high as 30-40%) operate in a way that cannot be statistically distinguished from perfect competition. Of course theoretical model of perfect competition only exist on paper like the concept on triangle, but there are many objects in real life that are shaped like triangle (eg the give right of way traffic sign) that are so triangle like that they could not be distinguished away from real triangle and you can apply Pythagorean theorem to them despite that 'real' triangle $\endgroup$
    – 1muflon1
    Jan 17 at 16:10
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Then a sizeable proportion of employers would need to do this to make a difference.

If we take the statement literally that it's talking about just one employer, rather than the effect in general of employers doing this, and the employer is not a significant portion of the economy, then that's true. Your other two points, however, confuse microeconomics/local effects and macroeconomics/global effects.

Why does more liquidity imply more demand and thus higher prices?

This is more velocity than liquidity.

If a person has more money at their disposal, then they could "level up" their lifestyle, rather than buying more of what they used to.

Only by outbidding the people that would have otherwise bought the luxury goods. If those other people are also getting higher wages, how are you going to outbid them? And even if you do, now those other people have a bunch of money that they would have used on the luxury goods, which they'll use to bid up the prices of other stuff. You're just pushing the effect out of view. Your scenario doesn't change the fact that there is more money chasing the same amount of stuff, and so prices will be bid up.

People can and do save money. Some things (e.g., home ownership) have become so costly, that the impetus to save -- rather than splurge -- is quite high.

Same basic idea as above, just somewhat more subtle. If they put the money in a bank account, the bank's not going to just stick it in a vault and forget about it. They're going to loan it out, and with the magic of fractional reserve, that money will turn into more money. If they buy a house, someone is selling a house and therefore getting a wad of cash. If they're putting their money towards paying down a mortgage they already have, then, again, the bank is getting more money. Unless you're going something along the lines of just sticking the cash under your mattress, "saving" means putting the money back into the economy.

(Bonus question: If an employer felt it was "morally imperative" to not drive up inflation, then wouldn't they be duty bound to not increase their prices for the goods/services they provide?)

They would lose money if they don't raise prices. Unless they have a large bankroll, eventually they'll have to raise prices.

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As the 1muflon1 answer states the best argument you are already making is that single employer committing to such policy does not matter. This would not necessarily be true if every employer would try to pursue such policy. If one man stands up in theater he can see better, if everyone stands up everyone sees as much as they could see before.

Macroeconomic effect of any policy, no matter how bizarre, will be nil if the policy is pursed just by one systematically unimportant person/household/firm.

The issue that the other answers did not discuss is that inflation is one of the adjustment mechanism economy has to respond to shocks. For example, when there is supply shock caused by war that disrupts supply lines of important imports/exports (for example when EU tried to cut itself from RU gas) economy cannot continue operating as it did before and it has to adjust. Inflation combined with wage stagnation can be one such adjustment mechanism. Why?

Sadly, even seemingly unrelated things like increase in gas prices can make people's work worth less. For example, if you are cook and price of gas increases your real economic product automatically drops even if you are still cooking at same speed and skill. This is because increased costs of inputs simply eat up from the value of your output and product per worker is simply the output over number of workers.

When the economic product of workers drops most straightforward economic adjustment is decrease in wages. However, this is nearly impossible due to wage rigidity caused by unions, bargaining costs, minimum wages, psychology (people really dislike loosing an amount disproportionately more than they like gaining same amount i.e. loss aversion).

As you can learn in any macroeconomic textbook, inflation is a convenient release valve since what economically matters are the real wages which inflation erodes regardless of the contractual nominal wages. If every employer would commit to increase wages then it could actually lead to wage-price spiral, if some other pressure valve is not open.

The reason why wage-price spirals are rare is that usually there is some other pressure valve that can be used. However, the answer of computercarguy is very misleading in suggesting that the other pressure valve can be profit in most economies.

Profit, to certain extent, could be used to release pressure in closed economies or in economies with strict capital controls and prevent wage-price spiral. But the answer of computercarguy completely ignores that most economies in the world are open not closed. Especially west has very open economies, and minimal capital controls (IMF 2015). In an open economy return to capital and thus rate of profit has to be approximately equalized between country and international markets (once difference in exchange rate and purchasing power are accounted for). So unless government implements capital controls and other restrictions this is simply not a viable pressure valve to prevent wage-price spiral.

The pressure valve that is viable is increased unemployment. If increase in wages matches increase in inflation you can reach stable equilibrium without further inflation if some people get fired, so their income drops. This means that in aggregate there won't be extra aggregate demand. Yes some people get higher wage and spend more, but other people get fired and spend less.

This is the most plausible mechanism of adjustment in open economy. In closed economy profits could be used to greater extent, but as 1muflon1 points out only up to a limit given by the mark up.

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