Cost-Push Inflation vs. Demand-Pull Inflation

Cost-Push Inflation vs. Demand-Pull Inflation The general increase in the price for goods in an economy is called inflation, and it is most commonly measured by the consumer price index (CPI) and the producer price index (PPI). When measuring inflation, it is not simply the increase in price, but the percentage increase or the rate at which the price of goods is increasing. Inflation is an important concept both in the study of economics and in real life applications because it affects peoples purchasing power. Despite its simple definition, inflation can be an incredibly complex topic. In fact, there are several types of inflation, which are characterized by the cause that is driving the increase in prices. Here we will examine two types of inflation: cost-push inflation and demand-pull inflation. Causes of Inflation The terms cost-push inflation and demand-pull inflation are associated with Keynesian Economics. Without going into a primer on Keynesian Economics (a good one can be found at Econlib), we can still understand the difference between two terms. The difference between inflation and a change in the price of a particular good or service is that inflation reflects a general and overall increase in price across the whole economy.   Weve seen that inflation is caused by some combination of four factors. Those four factors are: Supply of money goes up  Supply of goods and services goes downDemand for money goes downDemand for goods and services goes up Each of these four factors is linked to the core principles of supply and demand, and each can lead to an increase in price or inflation. To better understand the difference between cost-push inflation and demand-pull inflation, lets look at their definitions within the context of these four factors. Definition of Cost-Push Inflation The text Economics  (2nd Edition) written by American economists Parkin and Bade gives the following explanation for cost-push inflation: Inflation can result from a decrease in aggregate supply. The two main sources of a decrease in aggregate supply are: An increase in wage ratesAn increase in the prices of raw materials These sources of a decrease in aggregate supply operate by increasing costs, and the resulting inflation is called cost-push inflation Other things remaining the same, the higher the cost of production, the smaller is the amount produced. At a given price level, rising wage rates or rising prices of raw materials such as oil lead firms to decrease the quantity of labor employed and to cut production. (pg. 865) To understand this definition, we must understand the aggregate supply.  Aggregate supply is defined as the total volume of the goods and services produced in a country or the supply of goods. To put it simply, when the supply of goods decreases as a result of an increase in the cost of production of those goods, we get cost-push inflation. As such, cost-push inflation can be thought of like this: prices for consumers are pushed up by increases in cost  to produce. Essentially, the increased production costs are passed along to the consumers. Causes of Increased Cost of Production Increases in cost could relate to labor, land, or any of the factors of production.  It is important to note, however, that the supply of goods can be influenced by factors other than an increase in the price of inputs. For instance, a natural disaster can also impact the supply of goods, but in this instance, the inflation caused by the decrease in the supply of goods would not be considered cost-push inflation. Of course, when considering cost-push inflation the logical next question would be What caused the price of inputs to rise? Any combination of the four factors could cause an increase in production costs, but the two most likely are factor 2 (raw materials have become more scarce) or factor 4 (demand for raw materials and labor have risen). Definition of Demand-Pull Inflation Moving on to demand-pull inflation, we will first look at the definition as given by Parkin and Bade in their text Economics: The inflation resulting from an increase in aggregate demand is called demand-pull inflation. Such inflation may arise from any individual factor that increases aggregate demand, but the main ones that generate ongoing increases in aggregate demand are: Increases in the money supplyIncreases in government purchasesIncreases in the price level in the rest of the world (pg. 862) Inflation caused by an increase in aggregate demand  is inflation caused by an increase in the demand for goods. That is to say that when consumers (including individuals, businesses, and governments) all desire to purchase more goods than the economy can currently produce, those consumers will compete to purchase from that limited supply which will drive prices up. Consider this demand for goods a game of tug of war between consumers: as demand increases, prices are pulled up. Causes of Increased Aggregate Demand Parkin and Bade listed the three primary factors behind increases in aggregate demand, but these same factors also have a tendency to increase inflation in and of themselves. For instance, an increase in the money supply is factor 1 inflation. Increases in government purchases or the increased demand for goods by the government is behind factor 4 inflation. And lastly, increases in the price level in the rest of the world, too, causes inflation.  Consider this example: suppose you are living in the United States. If the price of gum rises in Canada, we should expect to see fewer Americans buying gum from Canadians and more Canadians purchasing the cheaper gum from American sources. From the American perspective, the demand for gum has risen causing a price rise in gum; a factor 4 inflation. Inflation in Summary As one can see, inflation more complex than the occurrence of rising prices in an economy, but can further be defined by the factors driving the increase. Cost-push inflation and demand-pull inflation can both be explained using our four inflation factors. Cost-push inflation is inflation caused by rising prices of inputs that cause factor 2 (decreased supply of goods) inflation. Demand-pull inflation is factor 4 inflation (increased demand for goods) which can have many causes.