Higher Wages and Higher Prices Inflation involves changes in both prices and wages and may initially be caused by both. Therefore, in this essay I will examine two cases of inflation, one caused by a change in aggregate demand, and the other caused by a change in aggregate supply. Both of these factors will have a bearing on prices and wages. I will then examine the fiscal and monetary policy responses available to the government in both cases. In the first case, an increase in aggregate demand could lead to inflation. This type of inflation is called demand-pull inflation. An initial increase in the level of aggregate demand could be caused, for example, by an increase in government spending. This would cause the aggregate demand curve to shift to the right, and the short-run equilibrium point would shift up and to the right along the short-run aggregate supply curve. This would lead to an increase in prices and an expansion of GDP. However, this would place the economy above long-run aggregate supply, and therefore produce more than its long-run potential. This means that the economy operates with unemployment below the natural rate, and the resulting labor shortage will lead to higher wages. At first glance, there seems to be no reason why this should lead to a process of inflation rather than a simple one-off increase in prices. The following graph illustrates what might happen:[IMAGE]Real GDP starts at Y0, with prices at P0. However, as aggregate demand moves from AD0 to AD1, real GDP moves to Y1, accompanied by an increase in prices from P0 to P1. However, unemployment… middle of paper… caused more production and therefore more unemployment. The increase in unemployment destroys the bargaining positions of the unions, which will not be able to advance their wage demands. Likewise, commodity producers will begin to feel their market shrink as businesses respond to rising prices by reducing production, and are therefore unlikely to continue trading. price increases unless the government takes into account the shocks they are causing. Bottom line, whether prices are pushing up wages through demand-push inflation, or wages are pushing up prices through cost-push inflation, the best course of action It seems sensible for governments to maintain strict control over price trends. money supply. Perhaps at times it might be preferable to loosen monetary controls slightly to increase employment, but the price for this will always be inflation..