With so much evidence of rising inflationary expectations, most blame higher oil prices, or rising wage levels, for the higher consumer prices. These fears reveal a common mistake of economic analysis that rising costs, either due to demands for higher wages or higher commodity prices, are the cause of rising consumer prices.
As it turns out, inflationary pressures have nothing to do with whether wage demands are held down or not or if there is a spike in oil prices or other inputs for production. A common misunderstanding of the nature and cause of inflation arises from a mistaken belief that prices are determined by costs. Following this line of reasoning, increased operating costs by businesses will lead to higher prices. In such a world, consumers are unable to resist higher prices and would passively accept them in such a manner that no company would go bankrupt.
But in the real world, firms file bankruptcy when they are unable to pass rising costs on to consumers because the valuation of the goods they sell is inextricably linked to demand. And since consumer utility ultimately determines price, the direction of cause-and-effect is such that prices determine costs, rather than the reverse.
Given that the value of goods depends upon satisfying human wants, prices can rise only if consumers perceive a sufficient value relative to the price of a good or service. This means that when more is demanded, more will be produced so that changes in the demand for goods or services also influence the demand for the inputs used to produce them. And so the cost of inputs can rise when the demand for finished output rises.
The suggested relationship between inflation and wages implies that central banks must increase interest rates to counter the inflationary effects of wages increases. But this piece of conventional wisdom ignores some basic preceptions about how markets work and how prices and wages are set.
In the first instance, there is an implication that the quantity of money is passive and adjusts itself to accommodate wage increases or rising commodity prices. However, the reverse is true
