By Bjorg Eggerts
Design by Bjorg Eggerts
Inflation can be viewed as part of an upward spiral, often called an inflationary spiral or wage-price spiral.
A spiral is a process where effects feed back into their causes:
Upward spiral: Prices rise → workers demand higher wages → businesses raise prices to cover costs → workers demand even higher wages → and the cycle continues.
Downward spiral: Prices and demand fall → businesses reduce investment and employment → incomes fall → demand falls further → and the cycle continues.
Inflation is therefore an example of a positive feedback loop that can create an upward spiral under certain conditions. However, not all inflation is caused by spirals. Inflation can also come from:
Higher import prices,
Supply shortages,
Currency depreciation,
Strong consumer demand,
Tax or regulatory changes.
In Iceland, economists often watch for wage-price spirals because wage settlements, housing costs, and exchange-rate movements can all contribute to persistent inflation. The Central Bank’s monetary policy aims to break such upward spirals by reducing inflation expectations and slowing demand when necessary. 12
inflation can be an example of an upward spiral, while deflation can be an example of a downward spiral.
We can also mentally be in a positive spiral or negative spiral. If it goes well we are in a positive spiral but the opposite if it is downward spiral, then we must try to break it and do something to transform the situation.
To break an inflation spiral, you have to interrupt the feedback loop that keeps pushing prices and wages upward.
The inflation spiral
Prices rise.
Workers demand higher wages.
Businesses face higher costs.
Businesses raise prices.
Prices rise again.
Ways to break it
1. Reduce demand Central banks can raise interest rates, making borrowing more expensive and encouraging saving. This tends to slow spending and reduce pressure on prices. The Central Bank of Iceland has used higher interest rates as part of its inflation-fighting strategy. 12
2. Anchor expectations If people believe inflation will remain high, they act accordingly by demanding larger wage increases and raising prices preemptively. A credible central bank helps convince households and businesses that inflation will fall. The Central Bank’s inflation forecasts are an important part of this process. 3
3. Improve productivity If workers produce more output per hour, wages can rise without requiring equivalent price increases.
4. Increase supply Building more housing, improving infrastructure, and removing bottlenecks can reduce shortages that contribute to price increases.
5. Responsible wage agreements Moderate wage settlements can help prevent wage increases from feeding directly into higher prices. At the same time, workers’ purchasing power needs to be protected.
A simple analogy
Think of inflation as a fire:
Higher interest rates reduce the oxygen.
More housing and production remove the fuel.
Stable expectations stop people from adding more wood to the fire.
The goal is not just to lower inflation temporarily, but to convince everyone that future inflation will be lower. Once people stop expecting rapid price increases, the spiral often weakens and eventually breaks.
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