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A wage-price spiral is a dynamic process that can be triggered by a cost-push shock, such as increased union power. After the initial shock raises inflation, workers and firms begin to expect higher inflation in the future. These updated expectations cause the Phillips curve to shift upward, leading to another round of inflation. This cycle of rising expectations and upward shifts in the Phillips curve can result in a continuous, year-over-year increase in inflation if not addressed by policy intervention.

Wage-Price Spiral from a Cost-Push Shock

Analyze the economic process that best explains why inflation continued to rise in Year 2, even after the initial cost shock had disappeared.

Analyzing Persistent Inflation

Following a significant, economy-wide increase in negotiated labor costs (a cost-push shock), a self-perpetuating inflationary cycle can begin. Arrange the following events to correctly illustrate the sequence of a wage-price spiral.

An economy, initially experiencing stable inflation, is hit by a one-time 'cost-push' shock where labor unions successfully negotiate significantly higher wages for workers. Analyze the process through which this single event can evolve into a persistent, year-over-year increase in inflation, commonly known as a wage-price spiral. Your analysis must clearly explain the critical role that the *expectations* of workers and firms play in sustaining this cycle.

The Dynamics of a Wage-Price Spiral

An economy experiences a one-time supply shock that raises production costs for all firms, leading to an initial increase in the inflation rate. For this single event to trigger a persistent, self-perpetuating wage-price spiral, which of the following mechanisms is most essential?

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