The intricacies of economies around the world can often be difficult to understand and how they are impacted by various subtle issues. Two such elements are wage inflation and cost of living inflation which tend to vary significantly and can eat away at the relative value of your money. The best way to demonstrate the dangers of low wage inflation and high cost of living inflation is to give you some figures.
Let us look at household budgets and the ever increasing cost of living. To simplify matters we will assume household income of $1500 a month and household expenditure of $1000 a month. This leaves a surplus to spend in other areas of everyday life of $500 a month. Let us assume wage inflation is running at 1% per annum while cost of living inflation is running at 4% per annum.
In the first year, income will be $1500 a month and expenditure $1000 a month – leaving a surplus of $500.
In year two, monthly income would have increased by 1% to $1515 but household expenses would have increased by 4% to $1040. This gives a surplus of $475.
In year five, monthly income would have increased to $1560 but household expenses would have increased to $1169. This leaves a surplus of just $391. Over a five-year period the monthly surplus has fallen by 21.8%.
The situation in year 10 is even more difficult, income has increased to $1640 a month but the cost of living has increased to $1423 a month leaving a surplus of just $217.
If the situation was to continue for 15 years then eventually the cost of living per month would have risen to a level greater than income per month. The figures for year 15 would be, monthly income of $1724 with monthly expenses of $1731, leaving a shortfall of seven dollars.
Controlling cost of living inflation
It is imperative that governments and central banks around the world are able to use various monetary levers to attempt to control the cost of living inflation. This is why they tend to use interest rates as a means of encouraging and discouraging borrowing. If the economy is struggling they reduce the cost of finance to encourage increased consumer spending. If the economy is in a boom situation they will likely look to increase the cost of borrowing to reduce consumer spending. This would also help to avoid a possible boom and bust scenario.
The above figures show exactly how the spending power of consumers is under constant pressure over the longer term. Companies will always look to keep their costs as low as possible to retain a competitive edge in the marketplace. It is very rarely, if ever, that you will see wage inflation increasing at a rate which is greater than cost of living. So, while many will make derogatory remarks about the unions and the pursuit of employee rights, somebody needs to stand-up for employees.
If the cost of living increases at a greater rate than household income then gradually over time the spending power of households will be eroded. This is just one of the many constant challenges faced by central banks and governments around the world on an ongoing basis. How would you even attempt to maintain relative household spending power when cost of living inflation is powering ahead of wage inflation?