Demand-pull and cost-push inflation

Overview

Demand-pull inflation and state the diagrammatic change that represents it, cost-push inflation and state the diagrammatic change that represents it and main causes of demand-pull inflation.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Define demand-pull inflation and state the diagrammatic change that represents it.

   Model answer

   Demand-pull inflation is a rise in the general price level caused by aggregate demand growing faster than the economy's ability to supply goods and services. On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, the AD curve shifts to the right along an upward-sloping short-run aggregate supply curve. At the new equilibrium both the price level and real output are higher, and the closer the economy is to capacity, the more of the adjustment falls on the price level rather than on output.

2. 2

   Define cost-push inflation and state the diagrammatic change that represents it.

   Model answer

   Cost-push inflation is a rise in the general price level caused by an increase in the costs of production faced by firms, independent of the level of demand. On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, the short-run aggregate supply curve shifts to the left. At the new equilibrium the price level is higher and real output is lower, so inflation and falling output occur together.

3. 3

   What is the single clearest diagnostic for telling demand-pull from cost-push inflation in the data?

   Model answer

   Look at what real output is doing at the same time as prices. With demand-pull inflation the price level and real output rise together, because the AD curve is moving along an upward-sloping supply curve, so unemployment is typically falling as well. With cost-push inflation the price level rises while real output falls, because the supply curve is moving along a downward-sloping demand curve, so unemployment is typically rising. Prices and output moving in the same direction indicates a demand shift; moving in opposite directions indicates a supply shift.

4. 4

   What are the main causes of demand-pull inflation, and which component of aggregate demand does each work through?

   Model answer

   A cut in interest rates or an expansion of credit raises consumption of durables and housing and raises investment. A tax cut or an increase in government spending raises disposable income and the government component directly. Rising consumer confidence raises consumption and reduces saving. A depreciation of the currency raises net exports by making exports cheaper abroad. Strong growth in trading partners' incomes also raises exports. Each of these shifts the AD curve to the right, and the inflationary consequence depends on how much spare capacity exists when it happens.

5. 5

   What are the main causes of cost-push inflation, and how does each raise firms' costs?

   Model answer

   A rise in world commodity or energy prices raises the cost of fuel and raw material inputs. Wage settlements running ahead of productivity raise labour costs per unit of output. A depreciation of the currency raises the domestic price of imported components and materials. Higher indirect taxes such as VAT or environmental levies raise the cost of bringing goods to market. A supply disruption, whether from conflict, harvest failure or transport bottlenecks, raises input prices through scarcity. Each shifts short-run aggregate supply to the left.

6. 6

   A depreciation of the pound can cause both demand-pull and cost-push inflation. Explain both channels.

   Model answer

   On the demand side, a weaker pound makes UK exports cheaper in foreign currency and imports dearer at home, so net exports rise and aggregate demand shifts right, raising the price level through demand-pull pressure. On the cost side, the same depreciation raises the sterling price of imported energy, food and components, which raises firms' costs and shifts short-run aggregate supply left, raising the price level through cost-push pressure. Both effects push prices up, but they move output in opposite directions, so the net effect on real GDP is ambiguous while the effect on prices is unambiguous.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.