Aggregate supply is the total amount of goods and services produced by an economy at a given price level. A reduction in the aggregate supply caused by a raise in the cost of production due to an increase in factors of production, therefore, causes cost-push inflation. An increase in the production cost leads to a rise in price levels of goods and services.
Workers of a company may want higher wages due to the high cost of living. 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 costs incurred by the company will be passed to the consumers in the form of an increase in prices.
Raw materials can also cause an increase in prices of commodities. Companies that import their raw materials may incur taxes by the state or they may be more expensive due to the depreciation of the country’s currency. Consequently, prices of commodities increase.
Demand-pull inflation occurs when there is an increase in aggregate demand. In demand-pull inflation, there exist an excess demand for limited goods and services. All the four sectors of the economy compete for the demand of the too few units of goods and/or services available. Therefore, “too much money chasing too few goods” induces inflation.
The growth of countries abroad can also increase inflation. Since there is more demand for exports the foreigners are consuming and this causes inflation in the domestic country.
When the government reduces taxation rates, individuals, in turn, remain with more disposable income. Consumer spending, therefore, increases and aggregate demand also increases leading to demand-pull inflation.
Cost-push inflation is most likely to take place if unemployment rates are:
B. Both high and low
The correct answer is A.
When unemployment rates are low, labor costs are high, hence creating low demand for labor.
Reading 17 LOS 17h:
Distinguish between cost-push and demand-pull inflation