Rising Prices and Rising Demand

Readers Question From Why inflation makes it easier to pay government debt

1. Why will wages increase with inflation?

There is no law that inflation will automatically lead to higher nominal wages. It is possible for inflation to be higher than nominal wage growth. In this case workers see a fall in real wages ( a fall in living standards). However, generally increased inflation does lead to higher wages. For example, in the 1970s, we saw inflation of over 20%, but wages were keeping pace with inflation.

In theory if a firm puts up its prices 20%, it will receive more revenue to be able to pay 20% more for factors of production like wages / raw materials. Generally, inflation means firms can afford to pay workers more.

2011 is a rare example of a situation where inflation is rising faster than wages, leading to a decline in real wages –– but this is relatively rare since 1945.

2. “If prices increase, VAT receipts will also increase”. This is based on the assumption that the demand remains the same. However, with increase in prices, demand will fall. Am i right?

It depends. But, if we assume that higher prices lead to higher wages, then workers will be able to afford the higher prices and continue to buy the same quantity. Therefore, VAT revenue will increase.

Also, in a period of economic expansion, inflation is caused by rising aggregate demand, i.e. people have more money and so the higher demand contributes to the rise in the general price level.

Therefore rising prices doesn’t necessarily lead to lower demand. It is often higher demand that causes rising prices!

However, if prices increased but wages didn’t, then consumers may not be able to afford as many goods; this could lead to lower VAT revenue.

Micro Economic Theory


Suppose one good increased in price (e.g. flat screen TV) by 10%, but inflation was 0%, then we would expect the higher price of TV to lead to lower demand for that good. In other words TV’s are relatively more expensive so we spend less on buying a new TV.

However, in the case of demand pull inflation. The price of all goods is rising because there is more demand in the economy. Therefore the higher prices don’t lead to lower demand.


By on August 10th, 2011

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