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January 20 2005 | Filed Under Economics , Entrepreneur
Do you remember how much less you paid for things even two years ago? This
increase in the general price level of goods and services in an economy is
inflation, measured by the Consumer Price Index and the Producer Price Index.
(see All About Inflation and What is inflation?) But there are different types
of inflation, depending on its cause. Here we examine cost-push inflation and
demand-pull inflation.
Factors of Inflation
Inflation is defined as the rate (%) at which the general price level of goods
and services is rising, causing purchasing power to fall. This is different
from a rise and fall in the price of a particular good or service. Individual
prices rise and fall all the time in a market economy, reflecting consumer
choices or preferences and changing costs. So if the cost of one item, say a
particular model car, increases because demand for it is high, this is not
considered inflation. Inflation occurs when most prices are rising by some
degree across the whole economy. This is caused by four possible factors, each
of which is related to basic economic principles of changes in supply and
demand:
Increase in the money supply.
Decrease in the demand for money.
Decrease in the aggregate supply of goods and services.
Increase in the aggregate demand for goods and services.
In this look at what inflation is and how it works, we will ignore the effects
of money supply on inflation and concentrate specifically on the effects of
aggregate supply and demand: cost-push and demand-pull inflation.
Cost-Push Inflation
Aggregate supply is the total volume of goods and services produced by an
economy at a given price level. When there is a decrease in the aggregate
supply of goods and services stemming from an increase in the cost of
production, we have cost-push inflation. Cost-push inflation basically means
that prices have been pushed up by increases in costs of any of the four
factors of production (labor, capital, land or entrepreneurship) when companies
are already running at full production capacity. With higher production costs
and productivity maximized, companies cannot maintain profit margins by
producing the same amounts of goods and services. As a result, the increased
costs are passed on to consumers, causing a rise in the general price level
(inflation).
Production Costs
To understand better their effect on inflation, let s take a look into how and
why production costs can change. A company may need to increases wages if
laborers demand higher salaries (due to increasing prices and thus cost of
living) or if labor becomes more specialized. If the cost of labor, a factor of
production, increases, the company has to allocate more resources to pay for
the creation of its goods or services. To continue to maintain (or increase)
profit margins, the company passes the increased costs of production on to the
consumer, making retail prices higher. Along with increasing sales, increasing
prices is a way for companies to constantly increase their bottom lines and
essentially grow. Another factor that can cause increases in production costs
is a rise in the price of raw materials. This could occur because of scarcity
of raw materials, an increase in the cost of labor and/or an increase in the
cost of importing raw materials and labor (if the they are overseas), which is
caused by a depreciation in their home currency. The government may also
increase taxes to cover higher fuel and energy costs, forcing companies to
allocate more resources to paying taxes.
Putting It Together
To visualize how cost-push inflation works, we can use a simple price-quantity
graph showing what happens to shifts in aggregate supply. The graph below shows
the level of output that can be achieved at each price level. As production
costs increase, aggregate supply decreases from AS1 to AS2 (given production is
at full capacity), causing an increase in the price level from P1 to P2. The
rationale behind this increase is that, for companies to maintain (or increase)
profit margins, they will need to raise the retail price paid by consumers,
thereby causing inflation.
Demand-Pull Inflation
Demand-pull inflation occurs when there is an increase in aggregate demand,
categorized by the four sections of the macroeconomy: households, businesses,
governments and foreign buyers. When these four sectors concurrently want to
purchase more output than the economy can produce, they compete to purchase
limited amounts of goods and services. Buyers in essence bid prices up ,
again, causing inflation. This excessive demand, also referred to as too much
money chasing too few goods , usually occurs in an expanding economy.
Factors Pulling Prices Up
The increase in aggregate demand that causes demand-pull inflation can be the
result of various economic dynamics. For example, an increase in government
purchases can increase aggregate demand, thus pulling up prices. Another factor
can be the depreciation of local exchange rates, which raises the price of
imports and, for foreigners, reduces the price of exports. As a result, the
purchasing of imports decreases while the buying of exports by foreigners
increases, thereby raising the overall level of aggregate demand (we are
assuming aggregate supply cannot keep up with aggregate demand as a result of
full employment in the economy). Rapid overseas growth can also ignite an
increase in demand as more exports are consumed by foreigners. Finally, if
government reduces taxes, households are left with more disposable income in
their pockets. This in turn leads to increased consumer spending, thus
increasing aggregate demand and eventually causing demand-pull inflation. The
results of reduced taxes can lead also to growing consumer confidence in the
local economy, which further increases aggregate demand.
Putting It Together
Demand-pull inflation is a product of an increase in aggregate demand that is
faster than the corresponding increase in aggregate supply. When aggregate
demand increases without a change in aggregate supply, the quantity supplied
will increase (given production is not at full capacity). Looking again at the
price-quantity graph, we can see the relationship between aggregate supply and
demand. If aggregate demand increases from AD1 to AD2, in the short run, this
will not change (shift) aggregate supply, but cause a change in the quantity
supplied as represented by a movement along the AS curve. The rationale behind
this lack of shift in aggregate supply is that aggregate demand tends to react
faster to changes in economic conditions than aggregate supply.
As companies increase production due to increased demand, the cost to produce
each additional output increases, as represented by the change from P1 to P2.
The rationale behind this change is that companies would need to pay workers
more money (e.g. overtime) and/or invest in additional equipment to keep up
with demand, thereby increasing the cost of production. Just like cost-push
inflation, demand-pull inflation can occur as companies, to maintain profit
levels, pass on the higher cost of production to consumers prices.
Conclusion
Inflation is not simply a matter of rising prices. There are endemic and
perhaps diverse reasons at the root of inflation. Cost-push inflation is a
result of decreased aggregate supply as well as increased costs of production,
itself a result of different factors. The increase in aggregate supply causing
demand-pull inflation can be the result of many factors, including increases in
government spending and depreciation of the local exchange rate. If an economy
identifies what type of inflation is occurring (cost-push or demand-pull), then
the economy may be better able to rectify (if necessary) rising prices and the
loss of purchasing power. (see What Is Fiscal Policy? and Why The CPI Is A
Friend To Investors.)
by Reem Heakal