What this lesson teaches
I can explain demand-pull and cost-push inflation.
Syllabus K343, 4.7.3. Causes of inflation: demand-pull; cost-push
Make a guess
World oil prices double, and prices rise across the economy. Which type of inflation is this?
- Cost-push, because firms' costs have risen.
- Neither, because oil is just one good among many.
- Demand-pull, because people want more oil.
Show the answer
Cost-push, because firms' costs have risen.
Oil is used for transport and power. Higher costs push firms to raise prices, even though demand has not risen.
Demand-pull inflation comes from total demand growing faster than output; cost-push comes from rising costs of production.
Demand-pull inflation happens when total demand rises faster than the economy can increase output. Too much money chases too few goods. Firms cannot keep up with orders, so they raise prices.
Causes of higher demand include rising consumer confidence, lower interest rates, tax cuts, more government spending, and strong demand for exports. The pressure is greatest when the economy is near full employment, because there are few idle workers or machines.
Cost-push inflation happens when firms' costs of production rise and they pass them on as higher prices. Causes include higher wages, dearer imported raw materials such as oil, and higher indirect taxes. A fall in the exchange rate also makes imports dearer.
The two can feed each other. When prices rise, workers ask for higher wages. Higher wages raise costs, and firms raise prices again. This is a wage-price spiral.
Sort these
Sort each cause of rising prices into demand-pull or cost-push inflation.
Groups: Demand-pull inflation, Cost-push inflation.
- The currency falls, making imported parts dearer.
- Wages rise faster than output per worker.
- A big income tax cut near full employment.
- Interest rates are cut and households borrow to spend.
- The price of imported oil doubles.
- Strong demand for exports when factories are already busy.
Show the answer
Demand-pull inflation
- A big income tax cut near full employment. Households spend more when there are few idle resources to meet it.
- Interest rates are cut and households borrow to spend. Spending rises faster than output can grow, so firms raise prices.
- Strong demand for exports when factories are already busy. Extra orders cannot be met quickly, so prices are pulled up.
Cost-push inflation
- The currency falls, making imported parts dearer. Higher import costs raise firms' costs of production.
- Wages rise faster than output per worker. Each unit costs more in labour, so firms pass the cost on.
- The price of imported oil doubles. Transport and power cost more for nearly every firm, which pushes prices up.
- Demand-pull
- Total demand grows faster than output.
- Cost-push
- Rising costs (wages, imported materials, taxes) passed on in prices.
- Wage-price spiral
- Higher prices lead to higher wages, which lead to higher prices.
Worked example: Spotting the cause
Identify the type of inflation in each case.
- Global oil prices double, raising transport and electricity costs: cost-push.
- Tax cuts and cheap loans lead to a spending boom near full employment: demand-pull.
- The currency falls sharply, so imported food and parts cost more: cost-push.
- Workers win large pay rises after prices rise, and firms raise prices again: a wage-price spiral.
Watch out for this
Inflation is caused by greedy firms deciding to raise prices.
Firms raise prices when demand outstrips supply or when their costs rise. Economists explain inflation through these demand and cost pressures.
Check your understanding
Consumer spending booms and firms cannot keep up with orders. Which kind of inflation is most likely?
- None, since more orders raise output, not prices
- Demand-pull, since total demand outruns output
- Cost-push, since imported inputs now cost firms more
Show the answer
Demand-pull, since total demand outruns output
Right. Spending grows faster than firms can produce, so they raise prices.
Check your understanding
Which is most likely to cause cost-push inflation?
- A cut in income tax that raises spending
- A rise in consumer confidence and spending
- A sharp rise in the world price of oil
- A fall in wages across the economy
Show the answer
A sharp rise in the world price of oil
Right. Firms' fuel and transport costs rise, and they pass them on as higher prices.