Inflation, the rise in the prices of goods and services, can be driven by different factors. Two important types of inflation are cost-push and demand-pull inflation. Economists have identified several other types of inflation but they are beyond the remit of this article.
Differentiating between cost-push and demand-pull inflation is essential to grasp their impact on the economy and assess their desirability. This article aims to elucidate the disparities between cost-push inflation and demand-pull inflation, explaining their distinct origins, consequences, and relative desirability.
Cost-push inflation occurs when the production costs of goods and services increase, leading to higher prices. It stems from rising expenses, such as raw materials, wages, and energy. When businesses face elevated production costs, they pass them on to consumers by raising prices. This, in turn, sets off a cycle of inflation, with increased costs being the initial trigger.
Demand-pull inflation emerges when the overall demand for goods and services exceeds the available supply in the economy. It arises when consumers possess greater purchasing power and are willing to spend more. As demand outstrips supply, producers respond by increasing prices to capitalize on the heightened consumer interest. This interplay between demand and supply dynamics fuels demand-pull inflation.
Cost-push and demand-pull inflation exhibit distinct characteristics:
- Causes: Cost-push inflation arises from rising production costs, such as higher wages or increased prices of raw materials. Demand-pull inflation, in contrast, stems from excessive aggregate demand surpassing the available supply.
- Initiating Factors: External factors, such as energy price hikes, tax policy changes, or disruptions in supply chains, often trigger cost-push inflation. Demand-pull inflation, however, is fuelled by factors like robust consumer spending, increased investments, or government stimulus.
- Supply-Side vs. Demand-Side: Cost-push inflation is more closely tied to supply-side factors since it originates from rising input costs that affect producers. Demand-pull inflation, on the other hand, primarily reflects demand-side factors, highlighting the role of consumers and their spending behaviour.
- Cyclical Effects: Cost-push inflation tends to be more volatile and cyclical, as it depends on fluctuations in production costs. Demand-pull inflation, while also cyclical to some extent, is more closely associated with broader economic trends and consumer sentiment.
Desirability of Cost-Push vs. Demand-Pull Inflation
Determining the desirability of cost-push and demand-pull inflation depends on various economic perspectives:
- Stability: Demand-pull inflation is generally seen as desirable since it indicates a healthy and growing economy. It reflects increased consumer confidence, higher spending, and can stimulate investment and economic growth. In contrast, cost-push inflation is often viewed as undesirable because it can reduce consumer purchasing power, lower business profitability, and impede economic expansion.
- Policy Response: Central banks and policymakers respond differently to each type of inflation. To control demand-pull inflation, they may tighten monetary policy, such as raising interest rates, to reduce overall demand. Addressing cost-push inflation requires different measures, such as supply-side policies aimed at tackling the underlying causes, like reducing regulatory burdens or enhancing productivity.
- Distributional Impacts: The impact of inflation on different segments of society can vary. Demand-pull inflation, with its positive economic indicators, may benefit a wide range of individuals. Cost-push inflation, however, can create challenges, particularly for those with limited purchasing power, as it erodes the value of their income.
When Raising Interest Rates is Suitable
Demand-pull inflation occurs when aggregate demand exceeds the available supply of goods and services. By raising interest rates, central banks aim to reduce overall demand in the economy. When interest rates increase, borrowing becomes more expensive, which discourages consumer spending and investment. This decrease in demand helps to mitigate the upward pressure on prices and can eventually lead to a slowdown in inflation.
By raising interest rates, central banks aim to control excessive borrowing, limit spending, and curb inflationary pressures caused by robust demand. It is important to note that the effectiveness of interest rate hikes in reducing inflation depends on various factors, including the magnitude of the inflationary pressures, the responsiveness of consumers and businesses to interest rate changes, and the overall health and structure of the economy.
When Raising Interest Rates is Ineffectual
However, it’s worth mentioning that raising interest rates may have limited impact on cost-push inflation, as this type of inflation is driven by rising production costs rather than excessive demand. Addressing cost-push inflation requires different measures, such as supply-side policies aimed at tackling the root causes of increased input costs such as reducing the regulatory barriers created by Brexit. The UK government’s mandate to the Bank of England to curb inflation has led to 13 straight increases in the base rate for borrowing (that now stands at 5%). If such factors as increased wages and higher energy prices have caused cost-push inflation then it is not surprising that the policy has been less than optimal in tackling inflation (the Consumer Price Index for the UK stands at 7.9%); and, such an approach to fighting inflation will have instead the undesirable impact of shrinking the economy and causing a recession.
Cost-push inflation and demand-pull inflation have distinct causes, implications, and desirability. While demand-pull inflation is often viewed as a sign of a healthy economy, cost-push inflation poses challenges due to its impact on production costs. Policymakers should respond differently to each type of inflation, utilizing specific strategies to manage their effects. Understanding these nuances aids in comprehending the dynamics of inflation and its implications for individuals, businesses, and the broader economy.