Demand Pull and Cost Push Inflation

Demand Pull and Cost Push Inflation

1. Demand Pull Inflation

The demand-pull inflation occurs when the aggregate demand increases at a much higher rate than the aggregate supply. In other words, demand-pull inflation occurs when, given the aggregate supply, aggregate demand increases substantially. Increase in aggregate demand may be caused by

i. monetary factors, i.e. increase in money supply and/or

ii. real factors, e., increase in demand for real output. Let us now sec how monetary and real factors cause inflation.

i. Increase in Money Supply

One important reason for demand-pull inflation is increase in money supply in excess of increase in potential output. Whether increase in money supply in excess of increase in output is the only cause of inflation is a controversial issue. But the fact is that monetary expansion in excess of increase in the level of output is one of the most important factors causing demand-pull inflation.

One important reason for demand-pull inflation is increase in money supply in excess of increase in potential output. Whether increase in money supply in excess of increase in output is the only cause of inflation is a controversial issue. But the fact is that monetary expansion in excess of increase in the level of output is one of the most important factors causing demand-pull inflation.

Let us look at the process of demand-pull inflation caused by monetary expansion. When monetary and real sectors are in equilibrium at die same level of output and prices, die economy is said to be in general equilibrium. The general price level corresponding to the general equilibrium is called equilibrium price level. Now let money supply increase, other things remaining the same. The increase

in money supply causes a decline in the interest rate. The decrease in die interest rate increase in transaction demand for money , especially for investment. Increase in investment causes increase in the level of income. Increase in income causes a rise in consumption expenditure. The rise in investment and consumer expenditures increases aggregate demand, aggregate supply remaining die same. This rise in aggregate demand is exactly proportional to the rise in the money stock. The rise in aggregate demand, given the aggregate supply, causes increase in the general price level. Thus, increase in money supply causes demand-pull inflation.

ii. Real Factors

Real-Factor demand-pull inflation can be caused by any or many of the following real factors.

  • Increase in the government expenditure without change in tax revenue;
  • Cut in tax rates without change in the government expenditure;
  • Increase in investment;
  • Increase in consume r demand;
  • Increase in exports given imports; and
  • Decrease in imports given the exports.

The first four factors straightaway increase the level of disposable income. Increase in aggregate income increases aggregate demand causing demand-pull inflation. For example, suppose that the government increases its spending financed through borrowings abroad. The rise in the government spending generates additional demand and. therefore, aggregate demand increases. Since there is, by assumption, full employment. additional resources can be acquired only by bidding a higher price. This pushes the prices up without increase in the output. Therefore, the transaction demand for money increases In order to meet the additional transaction demand for money, people sell their financial assets-bonds and securities. Consequently, bond and security prices go down and the rate of interest

In the product market, prices increase to such an extent that the additional government spending is absorbed by the price rise. This is how other real factors also cause inflation.

2. Cost Push Factors

Inflation is not caused by the demand-side factors alone. There are numerous instances of inflationary rise in prices which could not be fully explained by the demand-side factors. The 1958-recession in western countries is a famous instance. During this period of recession, aggregate demand had declined. Therefore, the general price level should have decreased but it did not. In recent times, it is a common experience that prices generally do not decrease during the period of recession. Furthermore, even when there is stagnation in the economy and there is no inflationary pressure, the general price level generally continues to increase, with a high rate of unemployment. The search for explanation to this kind of phenomenon, particularly for the 1958-puzzle, has lead to the emergence of supply-side theories of inflation, popularly known as cost-push theory and supply-shock theory of inflation.

The cost-push inflation is caused by the monopoly power exercised by some monopoly groups of the society, like labour unions and firms in monopolistic and oligopolistic market setting. It has been observed that strong labour unions often succeed in forcing money wages to go up causing prices to go up. This kind of rise in price level is called wage-push inflation. Not only labour unions, the firms enjoying monopoly power have also been found causing rise in the general price level. The monopolistic and oligopolistic firms push their profit margin up causing a rise in the general price level. This kind of inflation is called profit-push inflation. Yet another kind of cost-push inflation is said to be caused by supply shocks. Thus, the cost-push inflation may be classified on the basis of supply-side factors as follows.

i. Wage-push Inflation

ii. Profit-push Inflation, and

iii. Supply-shock Inflation

To these may be added some other kinds of supply-side factors, viz., minimum-wage legislation, and administered prices. The minimum-wage legislation is an intervention with the labour market. This prevents the downward adjustment in wages during the period of recession. Administered prices, for instance, fixing a minimum price for some sections of producers (e.g., oil price and minimum procurement price of food grains in India) prevent downward adjustment in prices during the period of good harvest and keep the prices artificially high for socio-political reasons. In this section, we will discuss briefly these kinds of cost-push inflation in theoretical mode.

i. Wage-Push Inflation

Wage-push inflation is attributed to the exercise of monopoly power by the labour unions to get their money wages enhanced more than the competitive labour market conditions would permit. Organized and powerful labour unions exercise their monopoly power and force their employers to increase their money wages above the competitive level without matching increase in labour productivity. Increase in money wages causes an equal increase in the cost of production. The increase in cost of production causes the aggregate supply curve shift backward. Given the aggregate supply curve, a backward shift in the aggregate supply causes an upward movement in the price level. However, every rise in the money wages is not always inflationary. The rise in money wages due to the following factors is not said to be inflationary.

  • increase in wage rate due to increase in productivity.
  • rise in wage rates due to inflation otherwise,
  • wage rise where unionized wage bill is very small, and
  • wage rise due to shortage of labour supply.

ii. Profit-Push Inflation

In contrast to wage-push inflation, profit-push inflation is caused by the use of monopoly power by the monopolistic and oligopolistic firms to enhance their profit margin which results into rise in price and inflation. Today, monopolistic competition and oligopolies characterize the real marker situation all over the world. The monopolies, monopolistically competitive firms and oligopolies account for the almost all manufacturing industries. Therefore, a profit-push type of inflation is certainly a theoretical possibility. The profit-push type of inflation is more common where labour unions demand higher wages. Firms increase prices of their products more than increase in the wage rate and create, thereby, an inflationary pressure. It may be added here that wage-push and profit-push inflation go hand in hand, whichever may be the leading cause. Labour unions may be the first to force wage rate to go up but firms raise the price level often more than proportionately. Or else, monopolistic firms may be the first to push the product price up forcing labour unions to demand a higher wage rate. It has then its repercussions on the money wages. Higher prices and profits induce demand for higher wages. The powerful labour unions force their wages up. Following the wage hike, firms raise the product prices. When this process gets going, it takes the form of “profit-wage spiral’.

iii. Supply-Shock Inflation

Supply shock is generally caused by unexpected decline in the supply of major consumer goods or key industrial inputs. For example, food prices shoot up due to crop failure, and prices of some key industrial inputs like, coal, steel, cement, oil, basic chemicals, etc., go up because of labour strike, natural calamities, etc. Also, rise in the price may be caused by supply bottlenecks in the domestic economy or international events (generally wars) causing bottlenecks in the movement of internationally traded goods and causing thereby shortage of supply and rise in imported industrial inputs.

Demand Pull and Cost Push Inflation

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