Built-in Inflation

Definition

Built-in inflation refers to the ongoing increase in prices due to adaptive expectations of future inflation, often driven by a wage-price spiral. It occurs when businesses and workers expect rising prices, leading them to adjust wages and prices accordingly, which perpetuates inflation even in the absence of other economic pressures. This phenomenon highlights the relationship between inflation expectations and actual inflation levels, creating a cycle that can be difficult to break.

5 Must Know Facts For Your Next Test

1. Built-in inflation is often linked to historical inflation rates as businesses and workers adjust their expectations based on past trends.
2. The wage-price spiral can exacerbate built-in inflation, as higher wages lead to increased production costs, further driving price increases.
3. Central banks may struggle to control built-in inflation because it is rooted in expectations rather than direct economic factors.
4. Policymakers can mitigate built-in inflation by managing inflation expectations through effective communication and policy measures.
5. Built-in inflation can persist even in a stagnant economy if expectations remain high, making it a significant concern for economic stability.

Review Questions

• How does the wage-price spiral contribute to the persistence of built-in inflation?
  • The wage-price spiral contributes to built-in inflation by creating a feedback loop where rising wages prompt businesses to increase prices to maintain their profit margins. As consumers face higher prices, they may demand even higher wages to keep up with the cost of living. This cycle continues, as businesses raise wages again in response to the increased cost of living, further fueling inflation. This dynamic illustrates how inflation expectations can become self-fulfilling over time.
• In what ways can central banks effectively manage built-in inflation without stifling economic growth?
  • Central banks can manage built-in inflation by carefully adjusting interest rates and using monetary policy tools to influence inflation expectations. By signaling their commitment to controlling inflation, they can help anchor public expectations and prevent a wage-price spiral from developing. However, they must balance these measures with the need to support economic growth, as aggressive tightening could lead to reduced investment and slower economic activity.
• Evaluate the impact of built-in inflation on long-term economic planning for businesses and governments.
  • Built-in inflation significantly affects long-term economic planning as both businesses and governments must account for persistent price increases when forecasting future costs and revenues. Businesses may face challenges in setting pricing strategies or wage structures due to unpredictable inflationary pressures. Meanwhile, governments must consider the implications of built-in inflation on fiscal policies, social programs, and overall economic stability. Failure to adequately address built-in inflation can result in misallocation of resources, erosion of purchasing power, and increased uncertainty in economic decision-making.

Related terms

Wage-Price Spiral: A situation where rising wages lead to increased costs for businesses, which in turn raise prices to maintain profit margins, prompting workers to demand higher wages.

Cost-Push Inflation: Inflation that occurs when production costs increase, leading businesses to raise prices to cover those costs.

Demand-Pull Inflation: Inflation that results from an increase in demand for goods and services, which outpaces supply and causes prices to rise.