Inflation: Cost-Push vs. Demand-Pull

Inflation: Cost-Push vs. Demand-Pull

The first quarter of 2022 was a watershed moment in terms of rising costs. Inflation in the United States rose at a 40-year high and has since been speeding up globally. The consumer price index increased at its quickest rate since January 1982, at 7.9% yearly, while fuel prices surged by 38% from a year ago. And the outlook for the rest of the year is bleak, as numerous events continue to pose significant pricing concerns.

However, even though inflation is a daily news story and widely known, few truly comprehend its causes and underlying mechanisms. This article will focus on the two factors that induce the gradual increase in prices that characterizes inflation, namely cost-push inflation and demand-pull inflation.

Cost-Push Inflation

Economists define Cost-push inflation as a situation in which the supply of products or services is limited in some way, but demand remains constant, resulting in increased prices. A rise in the price of manpower or raw materials, for example, causes a reduction in the supply of these resources. Commodity prices rise while demand remains steady, leading the overall price level to climb.

The general price level rises because of rising manufacturing costs, which is reflected in higher pricing for goods and commodities that predominantly employ these inputs. Simply put, a reduction in supply causes inflation.

Cost-push inflation is frequently linked to an unanticipated external event, such as a natural disaster or natural resource depletion, a monopoly, government regulation, government taxation, or changes in exchange rates. Essentially, anything that makes it difficult for a corporation to create enough of a given product to meet consumer demand. As a result, they are forced to raise or inflate prices.

Oil and natural gas prices are a good illustration of cost-push inflation since demand holds steady even when supply reduces due to global politics, wars, natural disasters, and other circumstances.

The energy crisis resulting from the recent conflict between Russia and Ukraine is a good example, with rising energy costs due to curtailed supply. In a similar vein, the Organization of Petroleum Exporting Countries (OPEC) monopolistic's status resulted in various cost-push inflation crises over time, such as the oil embargo in the 1970s.

To counteract cost-push inflation, procurement regulations that increase aggregate supply, such as tax cuts, contractionary monetary policies, and higher interest rates, can be implemented.

Figure 1: Oil prices, 2021-2022. Source: tradingeconomics.com

Demand-Pull Inflation

The rising pressure on prices caused by a supply shortage is known as demand-pull inflation. When the real gross domestic product rises, and unemployment reduces, prices rise. Economists usually refer to this predicament as “too many dollars for too few goods.”

In other words, demand-pull inflation occurs when an excessive number of people try to buy an insufficient number of goods. Unlike cost-push inflation, which is usually caused by a supply constraint, demand-pull inflation is triggered by an increase in aggregate demand, resulting in higher prices. It is worth noting that this is the most frequent cause of inflation.

Economic growth is the most typical cause of demand-pull inflation. Confident households are more likely to spend rather than save. Higher pay, improved employment prospects, a booming economy, property appreciation, and various other factors all contribute to this optimism. This climate encourages people to consume more, which inevitably leads to higher costs.

2021 was defined by the massive economic rebound that followed the Covid-19 outbreak. Favorable job figures, a low-interest rate environment, and increased market confidence boosted demand for products and services. However, when consumers demanded more than what was available, supplies quickly depleted. This increased demand drove prices up, creating the so-called demand-pull inflation.

Figure 2: Inflation measured by components (2010-2022). Source: Bureau of Economic Analysis

Disruptive technologies, interestingly enough, can also lead to demand-pull inflation. For example, over the last decade, Apple's market innovations have driven customer demands. As a result of the demand, Apple has been able to gradually raise its prices each year, creating the so-called demand-pull effect.

Other causes include inflation expectations, over-expansion of the money supply, discretionary fiscal policy, sudden surge in exports due to a significant undervaluation of a currency, or an excess of government spending.

Governments and central banks can employ restrictive monetary and fiscal steps to tackle demand-side inflation. Boosting the interest rate, which is analogous to counteracting cost-push inflation and decreasing government expenditure and raising taxes, all diminish demand.

Inflation: A Phenomenon with Multiple Causes

Whether caused by cost-push or demand-pull effects, it is essential to remember that inflation is a natural phenomenon in the economy and is not always negative. It can aid in the reduction of unemployment, wage adjustments, and economic stimulation.

Although too much inflation is generally considered bad for an economy, too little inflation can also be detrimental. It is a matter of striking a balance; inflation control is a major obligation of a country's financial regulator. It accomplishes so through monetary policy, which refers to the actions of a central bank or other bodies that determine the amount and rate of expansion of the money supply. Inflation of 2% per year tends to be considered healthy by many economists.

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