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 caused by a reduction in the aggregate supply caused by a rise in the cost of production (most often due to an increase in factors of production). In simpler terms, an increase in the costs of production leads to a rise in price levels of goods and services.

Workers may want higher wages due to the 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, then 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. Companies that import their raw materials may be more expensive due to the depreciation of the country’s currency or a rise in oil prices. Consequently, if the price of these commodities increases, 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 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 foreign countries can also increase demand-pull inflation. If the standard of living in a foreign country, say China, is rapidly increasing, this will create more demand in China for exported goods from abroad. These exporting countries will then have less of these goods circulating in their respective economies, which might limit the number of goods and services available domestically.

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.

Question

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

A. Low.

B. Both high and low.

C. High.

Solution

The correct answer is A.

When unemployment rates are low, labor costs are high, hence pushing prices higher.

Reading 17 LOS 17h:

Distinguish between cost-push and demand-pull inflation

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