The Minimum Wage and Inflation

Dear Dr. Dollar:

Would an increase of the minimum wage be inflationary? Would more inflation than we have now be a good or bad thing?
—Alex Searles, Boston, Mass.

The short answers to these two questions are: Not very much and it all depends. The “not very much” is evident from a simple example. The “it all depends” means that it all depends on who we’re are talking about when we ask the “good” or “bad” question. Like much else, who gains and who loses is a matter of power.

To begin with, let’s clear up what we mean by “inflation.” Inflation is a general rise in prices. This doesn’t mean that all prices go up, just that they go up on average. Some may go up a lot, some a little, and some may actually fall.

So what happens when the minimum wage is increased? Consider the situation in restaurants that have a middle-income clientele. Restaurant owners, facing a higher wage bill, would like to pass the costs on to their customers. But their customers are people whose incomes have not been affected much, if at all, by the higher minimum wage. So if prices at the restaurants go up, these people will buy less and the restaurants will now lose some profits. They may raise prices a bit, but not much. Whatever they do, the restaurant owners will have to, if you’ll pardon the term, eat some of the increased costs.

The point is that, with the increase of the minimum wage, firms that face higher costs cannot maintain profits simply by raising prices regardless of demand for their products. While the increase of the minimum wage will increase demand for those products purchased by low-income people, it will not yield an equal increase in demand for all products.

If low-income people tend to buy goods produced with low-wage labor—e.g., at McDonald’s—part of the increased wages will be eroded by increased prices. However, there is no reason to think that this erosion will wipe out much of the wage increase. On the other end of the income distribution—consider the purchases and prices of luxury cars. Certainly the rise of the minimum wage will not raise demand; it may even lower demand if profits are negatively affected. The price of luxury cars could even fall (but not by much!).

The upshot of all this: first, any inflation generated by an increase of the minimum wage is likely to be small; second, inflation affects different goods and thus different people very differently.

Especially important is how inflation affects debtors and creditors and how inflation affects wages (that is “real” wages, adjusted for inflation). Suppose a person takes out a loan for $1,000 this year, to be paid back next year with 10% interest, and suppose her salary is $1,000 per week. Then suppose prices in general—including her salary, which is, of course, a price—double. Now, instead of having to pay back more than a week’s salary, the person pays back with slightly more than half a week’s salary (55%). For this person, then, the inflation is pretty good. For her creditor, perhaps a bank, the inflation is pretty bad. (It is also pretty bad for people who are living on a fixed income—e.g., retirees who have a pension or annuity that pays a fixed amount each year.)

This example depends on what happens to wages relative to the general price increase. In some periods, when unemployment has been low and workers relatively powerful, wage increases have been greater than the rate of inflation—e.g., from the mid-1940s to the early 1970s. In subsequent years, with the conditions of labor very different, wages in general have barely kept pace with inflation. When working people do not have the power to defend themselves, they will most often be harmed by inflation. This is especially true when there are sudden upward spikes in the prices that form a large share of what people buy—as was the case with food and fuel prices a few years ago.

There is one more point—namely, that a little inflation is probably good for economic growth. If people with assets expect prices to rise, they will want to hold assets that rise along with the price increases. That is, they will want to make real investments (instead of holding cash). One of the factors retarding economic growth currently is that firms are sitting on larger amounts of cash. A bit of inflation could induce them to invest, which might yield more rapid economic growth. If the gains from growth, as in recent years, continue to be captured by the very wealthy, this is not so good. But at least growth opens some possibilities.