Higher Wages and Higher Prices Essay

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Higher Wages and Higher Prices Inflation involves changes in both prices and wages, and can be initially caused by either. Therefore, in this essay I will look at two cases of inflation, one, which is caused by a change in aggregate demand, and one, which is caused by a change in aggregate supply. Both of these will have relation to prices and wages. I will then examine the fiscal and monetary policy responses available to government in either case. In the first case, a rise in aggregate demand could lead to inflation. This kind of inflation is referred to as demand-pull inflation. An initial increase in the level of aggregate demand could be caused, for example, by a rise in government…show more content…
Real GDP falls back to its long run equilibrium level at Y0, and prices rise again to P2. However, since the economy is now in equilibrium again there seems no reason for further inflation. The only way that this could lead to inflation, rather than a one-off increase in prices, is if aggregate demand keeps increasing. This can only happen if the government allows the quantity of money supplied to constantly increase. An example of this is shown on the graph below. The money supply increases, causing a rise in prices and real GDP, but this is quickly followed by a rise in wages and a scaling-back of production which restores the economy to equilibrium unemployment with a higher price level. However, this is again followed by an increase in the money supply, and therefore aggregate demand, and the cycle continues to repeat itself. [IMAGE] This sort of inflation clearly involves wages following prices, the ultimate cause being an expansion of aggregate demand. This could be caused by governments overestimating the potential of the economy, and thus believing that the long run aggregate supply curve lies somewhere to the right of its actual position. In that case, governments might spend more money in order to try to get the economy back to its potential level. However, since they would in fact be attempting to cause
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