When the economy decreases in equilibrium output, the process of supply inflation starts. In practice, this is displayed using a spiral in the "salary - prices" system. The inflationary spiral is a situation where inflation is variablely supported as demand factors proposals as well, while the action of each factor will be caused by the action of the opposite. For example, with an increase in wages, there is a tendency to increase prices for goods and services.
This is logical, since more money supply, backed by hard currency, penetrates into circulation. Price growth, in turn, motivates raising salaries.
Inflationary Spiral: Development
Let us consider this phenomenon in detail. To do this, we should follow by example how the mechanism of the inflationary spiral works.
When the Central Bank unexpectedly raises money supply, it leads to growth aggregate demand which contributes to an increase in level demand inflation. At the same time, the salary level remains unchanged, therefore, employee income is reduced. This situation is the most common in the context of the global financial crisis. Not only the real income of people is reduced, but also the general standard of living. The cost of living is often greater than the minimum wage. This provokes the advancement of requirements for increasing wages in proportion to the increase in the level of prices in the market. This process increases the costs of the company and leads to a decrease in the total supply, as a result of which cost inflation. Prices continue to rise even more, while real incomes of workers are again declining. This again leads to demands for higher salaries. But the firm raises nominal income, not real, misleading workers who begin to increase consumer spending.
Demand inflation and inflation problems
This stage provokes the occurrence of demand inflation, which again leads to higher prices. As a result, real income falls again, again there is a demand for higher salaries and everything repeats. The standard of living is the proportion of money that a family spends on food. The higher the standard of living in the country, there a smaller share of their income is spent by the population on food. Similarly, with a low standard of living, the share of income spent on clothes and shoes is significantly reduced. With a high level of inflation, prices increase, as does the money supply in circulation. Real incomes are falling.
Thus, an inflationary spiral is unwound, in which each new round represents a higher level of inflation. This development is directly related to adaptive inflationary expectations, which are the difference between the expected inflation rate and the real level for the previous period.
Stages of the inflationary spiral
The inflationary spiral develops through certain stages:
- A sharp increase in costs (due to the deterioration of various conditions).
- Price increase.
- A decrease in the level of real wages, although the nominal may remain at the current level.
- The growth of nominal wages and lower profits due to increased money supply.
- The decline in production and rising unemployment with lower incomes and higher prices.
- Stimulating production through money supply.
- Growth in demand, production and prices.
- The beginning of a new stage.
The described model is static, in it the inflation process manifests itself in the form of a jump in prices. The government at each stage restores the volume of output to the desired level through monetary emission.
This is possible due to the lack of inflationary expectations of economic entities.
Supply stimulation and its impact on the inflationary spiral
When inflation expectations are taken into account, the inflation spiral deployment mechanism looks a little different. When supply stimulation occurs, the level of aggregate supply will increase, and demand will remain at the same position. If the state does not influence this situation, stagflation will occur - the process of stagnation of production combined with increasing unemployment and rising prices. But in this situation, the government, in order to restore production, begins to stimulate the growth of money. If everything is calculated correctly, the value of the national income level will be restored until the moment of inflationary processes. Aggregate demand will increase, but in the end, the level of supply will decrease again, which will again lead to a decrease in state revenue. In other words, a standard inflationary spiral will be observed.
Stability of inflation is a sign of problems
Based on all the above, we can conclude that the inflationary spiral is a system that constantly operates and develops in accordance with the stages of development of the state. This situation can be repeated many times until the moment of default or before the beginning of the strengthening of the national currency of the state. The absence of inflation and its decline is an indicator of the stable development of the state. This is the mechanism for the deployment of the inflationary spiral. 50% of states, and maybe more, cannot get out of it.
