Progressive Money

Economics in the Real World · scenario 4 of 10 · about 12 min

“Higher wages inevitably cause inflation.”

Why people make this argument

Wages are the biggest cost for many businesses, so it seems obvious that if wages rise, prices must follow. Most people have seen a café or a tradie put prices up 'because of wage costs'.

Economists talk about a wage-price spiral, in which workers push for pay rises to keep up with prices and firms raise prices again to cover the higher wages. The strongest version: when unemployment is very low, firms compete for scarce workers, wages grow faster than productivity, and if firms can pass on the extra cost, prices rise and people start to expect more inflation. People often point to the 1970s and early 1980s, when wages and prices rose rapidly together.

Ideas you'll need

What isn't in dispute

Labour is a large share of most firms' costs. If wages rise faster than labour productivity, the cost of producing each unit of output rises, which the RBA describes as pushing up prices. If wages grow in line with productivity plus the inflation target, unit labour costs rise only at about the target rate.

Over the year to December quarter 2022, the Wage Price Index rose 3.3 per cent while the CPI rose 7.8 per cent, so real wages fell during that surge. Whether a cost rise becomes a price rise also depends on firms' margins and on demand.

How mainstream economists would analyse it

The RBA's framework treats wages as an important channel, not an automatic one. When unemployment is below the NAIRU, wage growth tends to speed up and, if it outpaces productivity, firms pass on the higher costs. The bigger worry is expectations: if workers and firms expect high inflation and build it into pay deals and prices, inflation becomes harder to bring down.

On 2021–23, the RBA's own research attributed at least half of inflation over the year to March 2023 to supply factors. The RBA also argued in 2023 that domestic profit margins had not been a significant independent cause, and Treasury advice reached a similar view. Most mainstream economists would say wages rising with productivity are not inflationary, while wages rising well beyond it in a tight economy are.

How MMT economists would analyse it

MMT and other heterodox economists reject 'inevitably'. Wages are a cost, but firms set prices, and how much of a cost rise they pass on depends on their market power and on demand. Bill Mitchell, and researchers such as Jim Stanford at the Australia Institute, point out that real wages fell in 2022: wages were trailing prices, not leading them. Stanford estimated that profits accounted for far more of the inflation above the RBA's target than unit labour costs did. Isabella Weber describes a late 'conflict' stage in which workers try to recover lost real wages.

MMT economists accept that if wages and total spending outrun the economy's capacity, inflation follows. Their point is that pay rises in line with productivity, or that restore lost real wages, need not cause lasting inflation.

Your turn

Your turn: The Fair Work Commission is considering a large minimum wage rise. A business group says it will 'inevitably' fuel inflation. Evaluate the claim, saying when it would be more, and less, likely to be true.

Show a model response and the rubric

The claim is partly right. Wages are a big share of costs, and if they rise much faster than productivity, unit labour costs rise and many firms will pass that on, especially when demand is strong. If people come to expect that, inflation can become entrenched. That is the core of the RBA's concern.

But 'inevitably' is too strong. A pay rise in line with productivity plus the 2.5 per cent target midpoint adds little to unit labour costs. Whether a cost rise becomes a price rise also depends on margins, pricing power and demand. In 2022 wages rose 3.3 per cent while prices rose 7.8 per cent, so wages did not start that surge. A minimum wage decision also covers only part of the workforce.

The risk is greater if unemployment is well below estimates of the NAIRU, productivity is flat and firms have strong pricing power; smaller if the rise mainly restores lost real wages in a slowing economy. Evidence that would decide it: unit labour costs, margins by industry and inflation expectations after the decision.

A strong response

  • Distinguishes wage growth from unit labour cost growth, using productivity
  • Recognises that pass-through to prices depends on margins, pricing power and demand
  • Uses Australian evidence accurately, such as real wages falling in 2022
  • Explains the expectations channel the RBA emphasises
  • Specifies conditions under which the claim is more or less likely to hold

There is no single right answer. Reach your own conclusion, and be ready to say what evidence would change it.

Limitations and counterarguments

The heterodox case is strongest for 2021–23, when real wages fell. It says less about periods when wages ran well ahead of productivity in a tight economy, as many economists believe happened in the 1970s. Profit-share estimates are also sensitive to method: recent RBA work notes that margins can rise or fall for different reasons, so profits alone do not identify the cause of inflation.

The mainstream framing has limits too. The NAIRU is estimated with a band of about plus or minus one percentage point, so judging when wage growth is 'too fast' is uncertain, and a focus on wages can understate pricing power and supply shocks. Who should bear the cost of bringing inflation down is a value judgement, not a technical question.

Revisit Australia's Inflation Target · Sellers Inflation [Isabella Weber] · Isabella Weber: The Economics and Politics of Seller's Inflation · How the RBA thinks about unemployment and inflation

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