Cost-push and Demand-pull Inflation

Cost-push Inflation

Aggregate supply is the total amount of goods and services produced by an economy at a given price level. Cost-push inflation is attributed to a reduction in the aggregate supply caused by a rise in the cost of production (most often due to an increase in the cost of factors of production). In other words, an increase in production costs leads to a rise in price levels of goods and services.

Workers may agitate for higher wages due to high cost of living. Since labor is a factor of production, and the company has to allocate more resources for the production of one unit of goods and/or service, the extra cost incurred by the company will be passed on to the consumers in the form of an increase in prices.

Raw materials can also cause an increase in the prices of commodities. For example, companies that import their raw materials may tag high prices on their products due to the depreciation of the country’s currency value or a rise in oil prices. Logically, if the prices of raw materials increase, the extra cost has to be absorbed by the consumers.

Demand-pull Inflation

Demand-pull inflation occurs when there is an increase in aggregate demand. In demand-pull inflation, there exists an excess demand for limited goods and services. All the sectors of the economy scramble for the few units of goods and/or services that are available. Therefore, “too much money chasing too few goods” induces inflation.

The growth of foreign countries can also increase demand-pull inflation. For example, if the standard of living in a foreign country, say China, is rapidly increasing, there will be more demand for imported goods. The countries that export their goods to China, in such an instance, will have less of these goods circulating in their economies. This will consequently limit the number of goods and services at the disposal of their populations.

When the government reduces taxation rates, individuals remain with more disposable income. Consumer spending, therefore, increases, and aggregate demand also increases, leading to demand-pull inflation.

Question

Cost-push inflation is most likely to take place if unemployment rates are:

A. low;

B. at extremes, both high and low; or

C. high.

Solution

The correct answer is A.

When unemployment rates are low, labor costs are high. Since labor is a factor of production, and a company has to allocate more resources for the production of one unit of goods and/or service, then the extra cost incurred by the company will be passed on to the consumers in the form of an increase in prices.

Reading 15 LOS 15h:

Distinguish between cost-push and demand-pull inflation