Wage indexing, wage price spiral and the Belgian economy

Useful video that covers a lot of economic theory and events that have happened in the past. The wage indexation system in Belgium ensures that wages are linked to what they call the ‘Health Index’ this is similar to the consumer price index but doesn’t include items such as alcohol, tobacco and petrol. Wages increase once the four-month average of so-called Health index exceeds a certain threshold usually 2%. It explains the following:

• Indexation

• The wage-price spiral of 1970’s

• Oil crisis of the 1970’s & 1980’s

• Exports being a small % of GDP

Also interested to note in the comments section that Belgium has a strong welfare system as well as union protection of workers. Consumers there tend to be big savers which help the public debt issue.

Wage price spiral

Part of the CIE A2 macro syllabus focuses on the wage price spiral which relates to the Phillips Curve. As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices. Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate. The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

Sign up to elearneconomics for comprehensive key notes with coloured illustrations, flash cards, written answers and multiple-choice tests on wages and inflation that provides for users with different learning styles working at their own pace (anywhere at any time).