COLA is an acronym that refers to “cost of living adjustments” that are built into contracts or programs. For example, many union contracts have cost of living adjustments built in (e.g. “pay is $40,000 per year plus cost-of-living). As a result, if inflation rises, pay rises commensurately.
Many economists cite the frequency of COLA clauses as a mechanism by which inflationary spirals can occur. For instance, if inflation rises by 5% in a year, then the COLA clauses subsequently require wages to rise 5%, then inflation will rise even further.
COLA clauses are often tied to the Consumer Price Index, which is a common measure of inflation published by the Bureau of Labor Statistics (see the Inflation section for more details). This measure introduces additional controversy as many observers believe that the CPI systematically overestimates the increase in the cost of living by insufficiently accounting for substitution effects and quality changes. The Inflation section explains this phenomenon in more details, however at its core, people tend to substitute out equivalent products when they get more expensive (e.g. carpooling more when gas prices go up) so actual out-of-pocket expenditures may be less severe than mere price changes suggest. Moreover, goods tend to get higher-quality over time so while the sticker price of a TV may have changed little since 2000, the quality is degrees of magnitude better. If the CPI fails to sufficiently take into account those changes, then it might overestimate the extent to which prices have risen.