The idea of cost-push inflation emerged in the post-World War II period as a description of inflation that resulted from labour unions pushing up wages despite the existence of excessive unemployment. It will be convenient to refer to this as wage-push to distinguish it from supply shock inflation, another form of cost-push that dominated world price developments in the s when oil prices rose many-fold in two abrupt steps.
The idea of both wage-push and supply shock inflation is that prices are pushed up by a shift up in supply schedules rather than by an increase in demand along an unchanged supply curve.
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Cost-Push Inflation. Authors Authors and affiliations George L. Living reference work entry Later version available View entry history First Online: 26 November How to cite. This process is experimental and the keywords may be updated as the learning algorithm improves. This is a preview of subscription content, log in to check access. Select personalised ads. Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors.
Your Money. Personal Finance. Your Practice. Popular Courses. Economy Economics. Part Of. Understanding Inflation. Types of Inflation. What Does Inflation Impact? Understanding Hyperinflation.
Understanding CPI. Related Terms A-I. Related Terms J-Z. Cost-Push Inflation vs. Key Takeaways Cost-push inflation is the decrease in the aggregate supply of goods and services stemming from an increase in the cost of production. Demand-pull inflation is the increase in aggregate demand, categorized by the four sections of the macroeconomy: households, business, governments, and foreign buyers.
Demand-pull inflation can be caused by an expanding economy, increased government spending, or overseas growth. Article Sources. Investopedia requires writers to use primary sources to support their work.
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This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Articles. Macroeconomics Inflation vs. Stagflation: What's the difference? Macroeconomics Inflation for Dummies. Partner Links. The CPI measures the rate of inflation by the ratio of the consumer price index of one year over the base year or some other reference year.
This result is then multiplied by to yield an integer representation of the index. The inflation rate can, thus, be calculated by comparing the CPI of one year with that of the base year, or any other year:. However, the CPI only covers consumer goods and services.
The GDP deflator covers many more goods and services, including goods and services bought by businesses and governments, and goods and services traded internationally, all of which are items included in the gross domestic product GDP , but which are not consumer goods and services, and, therefore, not included in the CPI.
Since GDP is based on prices, the nominal GDP is the price of all goods and services in the current, or target, year; the real GDP is the value of all goods and services expressed in the prices of the base year. There are 2 types of inflation distinguished by cause: demand-pull inflation and cost-push inflation. Demand-pull inflation occurs when an increase in spending for goods and services outstrips the increase in economic output, when aggregate demand exceeds aggregate supply. Demand-pull inflation occurs when the money supply increases faster than the economy, and the money is used to buy goods and services.
This shifts the demand curve rightward, causing prices to rise for every level of output. As the economy grows, the money supply must increase proportionately. If the money supply grows too fast, then inflation results; if it grows too slowly, then deflation results.
Inflation not only depends on the supply of the money stock , the quantity of money , but also depends on how fast people spend it, the velocity of money. For an economy, the velocity of money is simply equal to the value of all transactions divided by the value of the money stock. Both quantity and velocity determine inflation, but without velocity, the quantity of money is immaterial.
For instance, if grandma wins a one million-dollar lottery, takes it as a lump-sum payment, then goes home and stuffs it in her big mattress, then it will have no effect on the economy.
It will be as if the money never existed. Although central banks control the availability of credit and the money stock, they cannot control the rate at which people spend the money. Sometimes, the money supply is increased by the easy availability of credit.
One of the best illustrations of demand-pull inflation occurred during , when real estate prices exploded, because banks started giving loans to anyone who could breathe.
The mortgages were packaged into mortgage-backed securities , which the banks then sold to investors, passing along the credit default risk of the mortgages to the investors. This took the mortgages off the banks' balance sheet, allowing them to make even more loans, which they did because they profited from the origination and servicing fees for the loans. This continual process increased demand much faster than the supply could increase, so demand-pull inflation resulted.
As long as the increase in economic output exceeds the increase in the money supply, there will be no demand-pull inflation.
As long as firms have idle capacity, increases in spending will cause the firms to use up their capacity before raising prices. However, as the economy nears full employment , and idle capacity becomes used up, it becomes increasingly difficult to increase output without significant additional investments, so prices rise.
The marginal cost of more production increases substantially as the limits of fixed capital and limited labor are reached, so businesses raise prices to pay for the increased expenses and to increase profits.
Generally, some demand-pull inflation is good because it indicates that the economy is closer to full output and that the unemployment rate is at its natural rate. This increases both economic growth and prosperity, which central banks try to maintain by allowing the money supply to grow only as fast as the economy. This keeps demand-pull inflation in check.
Note, however, that just increasing the money supply may not necessarily lead to inflation, at least in the short run. For instance, if most of the new money goes to the wealthy, they tend to invest the money, such as in the stock market, or by buying collectibles, such as art.
Such investments will not increase prices for most goods and services, which is what is measured by the CPI or the GDP deflator. Indeed, as the wealthy gain an ever larger share of the economic wealth, less of that wealth is used to purchase the goods and services of an economy, which will mitigate inflation.
This results because the wealthy have a lower marginal propensity to consume , since they already have most of the goods and services that they want. Instead, the wealthy buy status symbols, such as expensive art or stocks. In such cases, the prices of collectibles or financial instruments, such as stocks, will increase in price faster than increases in the CPI.
Demand-pull inflation is a monetary phenomenon, so it is natural to examine demand-pull inflation in terms of monetary variables. The quantity of money multiplied by the velocity of money equals aggregate demand , and when aggregate demand increases faster than economic output, then price levels must rise, which is inflation. The relationship between the quantity of money M , the velocity of money V , aggregate price levels P , and economic output Y are summarized by the following equation:.
Central banks conduct monetary policy with the primary objective of keeping inflation low. Low inflation allows consumers and businesses to manage their money more effectively, by keeping the value of money relatively stable and inflation predictable. However, central banks can only control the supply of money, they cannot directly control the velocity of money or economic output. The velocity of money is variable in the short run. Velocity tends to slow down when interest rates fall and increase when they rise.
However, this probably does not reflect causation, meaning that interest rate changes occur because of changes in velocity. Rather, velocity declines when the economy declines, which is when the Fed, or central banks in other economies, decreases interest rates.
When the economy is booming, velocity is high, and the Fed is increasing interest rates to cool the economy. For instance, money velocity declined after the Great Recession that began in , because people had no money to spend, so the Fed lowered interest rates to stimulate the economy. Thus, the lower velocity of money and decreased interest rates were caused by the slowdown in the economy. Without this common cause, it would be more natural to assume that money velocity would increase with lower interest rates, since lower interest rates generally increase consumption and investments in capital by businesses.
This decrease in velocity also explains why there was little inflation during the Great Recession, even though the Fed increased the money supply. People were deeply in debt, so they could not spend any more money, with the consequence that businesses could not sell their products and services, so they had to lay people off. Thus, increasing the money supply itself does not necessarily increase inflation, especially in a depressed economy.
However, over the long run, the velocity of money is considered constant, so an increased money supply relative to the growth of the economy leads to higher inflation. Sometimes inflation is caused by increases in the cost of inputs, or the factors of production, which gives rise to cost-push inflation. However, cost-push inflation does not occur as frequently as demand-pull inflation, especially in less developed countries, where politicians are inclined to solve monetary problems by printing more money, a major cause of demand-pull inflation in those nations.
Cost-push inflation arises as the per-unit production costs increase.
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