Wage-price dynamics describe how wages and prices interact. When unemployment falls below NAIRU, labor scarcity drives wages up; firms pass increases into prices, creating inflation. If expectations embed higher inflation, a wage-price spiral develops.
Trace a wage-price spiral: tight labor → wage demands rise → firms raise prices → inflation expectations rise → workers demand higher wages. Show how central bank credibility interrupts the spiral.
To understand wage-price dynamics, start from the NAIRU framework you already know. When unemployment falls below the non-accelerating-inflation rate, firms are competing for a shrinking pool of workers. To attract and retain employees, they raise wages. So far this is just a tight labor market. The inflationary spiral begins when those higher wages feed forward into prices: firms facing higher labor costs must either accept lower profit margins or raise the prices they charge customers. Most competitive firms do the latter, so a broad wage increase translates into a broad price increase.
Here is where expectations become decisive. If workers and firms treat the price increase as a one-time adjustment, the spiral stops. But if workers observe rising prices and conclude that the cost of living is permanently higher, they demand still-higher wages in the next contract negotiation — and the cycle begins again. This self-reinforcing mechanism is the wage-price spiral: each round of wage increases drives price increases, which drive further wage demands. The spiral is not automatic; it depends on whether inflation expectations become unanchored from the central bank's target.
The inflation process has a meaningful lag structure that distinguishes it from instantaneous price adjustment. Wages in many industries are set by multi-year contracts, so even when unemployment drops below NAIRU today, the wage response may not fully materialize for months or years as existing contracts expire and new ones are negotiated. Similarly, firms may absorb higher costs briefly before passing them through to prices. This lag means the Phillips curve relationship — lower unemployment predicts higher inflation — operates with delay, and policymakers must anticipate rather than react.
Central bank credibility is the mechanism that can interrupt the spiral before it becomes self-sustaining. If households and firms believe the central bank will raise interest rates aggressively enough to cool demand and return unemployment toward NAIRU, they may refrain from embedding higher inflation into wage and price-setting expectations. In this case, expectations remain anchored and the initial wage-price pressure dissipates without a full spiral. But if the central bank delays action or is perceived as insufficiently committed to its inflation target, expectations de-anchor, the spiral takes hold, and restoring price stability requires a much more painful demand contraction — a recession deep enough to re-establish that higher unemployment will discipline wage demands.
Finally, it is worth distinguishing this demand-pull story (unemployment below NAIRU pulls wages and prices up) from cost-push inflation, where a supply shock — say, an energy price spike — raises firms' production costs directly, before any labor market tightening. Cost-push shocks force an uncomfortable trade-off: letting prices rise to accommodate the shock, or suppressing demand to hold prices down at the cost of higher unemployment. Demand-pull and cost-push are not always cleanly separable in practice, but the distinction matters for policy because the appropriate response differs.