Causes of inflation: cost-push

Government and the Macro‑economy – Inflation

Objective

Students will be able to:

• Define inflation and deflation.
• Explain how inflation is measured using the Consumer Prices Index (CPI) and recognise its limitations.
• Distinguish between demand‑pull and cost‑push inflation, with particular focus on the causes of cost‑push inflation.
• Identify the main consequences of inflation for different groups in the economy.
• Describe the three categories of policy used to control inflation and evaluate their likely effectiveness.

Definition of Inflation & Deflation

Measuring Inflation – The Consumer Prices Index (CPI)

• What the CPI measures: the cost of a *fixed basket* of goods and services that a typical household buys. The basket is *weighted* to reflect the relative importance of each category (e.g., food, housing, transport, education, recreation).
• Formula:

  Inflation rate (%) = [(CPIt – CPIt‑1) / CPIt‑1] × 100

• Worked example:

  • Year 1 CPI = 120
  • Year 2 CPI = 126
  • Inflation = [(126 – 120) / 120] × 100 = 5 %

• Limitation (evaluation point – AO3): the CPI uses a fixed basket, so it does not fully capture *substitution bias* (when consumers switch to cheaper alternatives) and may over‑state the true cost‑of‑living increase.

Types of Inflation

Cost‑push Inflation

What it is

Cost‑push inflation occurs when the overall price level rises because firms’ production costs increase, prompting them to raise the prices of their output.

Key Causes (expanded)

• Rising wages – higher wage demands or statutory minimum‑wage increases raise labour costs.
• Higher raw‑material or energy prices – for example, a sudden rise in oil or metal prices.
• Supply‑side shocks – floods, earthquakes, or wars that reduce the availability of key inputs.
• Exchange‑rate depreciation – a weaker domestic currency makes imported raw materials and intermediate goods more expensive (e.g., a 15 % fall in the pound raises the cost of imported oil).
• Higher indirect taxes – increases in VAT or excise duties raise the cost of production and are passed on to consumers.

How Cost Increases Lead to Higher Prices

1. Input costs rise.
2. If firms keep prices unchanged, profit margins fall.
3. To protect profitability, firms raise the selling price of their output.
4. The aggregate price level rises → inflation.

Illustrative Example – Oil‑price shock

Assume oil, a major input for transport and manufacturing, rises by 20 %.

If oil‑related expenses account for 30 % of a typical firm’s total costs, the firm’s overall cost increase is:

ΔC = 0.30 × 0.20 = 0.06  (6 %)

To maintain its profit margin, the firm may raise its product price by roughly 6 %.

Short‑run AS Diagram (Cost‑push)

Price Level
^
|
P2   |          AS₂
|          /
P1   |   AS₁  /
|      /
|/ Real GDP
Y₂   Y₁

Explanation:

• AS₁ is the initial short‑run aggregate‑supply curve.
• Higher production costs shift SRAS leftward to AS₂.
• Equilibrium moves from (P₁, Y₁) to (P₂, Y₂): price level rises, real output falls.

Table – Common Cost‑push Factors and Their Typical Economic Impact

Demand‑pull Inflation

What it is

Demand‑pull inflation occurs when aggregate demand (AD) grows faster than the economy’s productive capacity, “pulling” the price level up.

Key Causes

• Strong consumer confidence → higher household spending.
• Expansionary fiscal policy – increased government expenditure or tax cuts.
• Expansionary monetary policy – lower interest rates, larger money supply.
• Export boom or surge in foreign investment raising national income.

Illustrative Example – Expansionary fiscal policy

Government raises spending by £10 billion while the economy is already near full employment. The extra spending shifts the AD curve rightward, moving equilibrium from (P₁, Y₁) to (P₂, Y₂). Because output cannot increase much beyond Y₁, the dominant effect is a rise in the price level → inflation.

Consequences of Inflation

Inflation affects different groups in distinct ways.

• Consumers – reduced purchasing power; real wages may fall if wages do not keep pace.
• Workers – may demand higher wages, leading to a wage‑price spiral.
• Firms – profit margins can be squeezed if they cannot pass higher costs onto customers; planning and budgeting become more difficult.
• Government – higher nominal tax revenues but also higher cost of borrowing; inflation can erode the real value of public debt but may increase the fiscal burden if index‑linked benefits rise.

Interaction Between Demand‑pull and Cost‑push Inflation

Both forces can operate simultaneously. A classic example is a wage‑price spiral:

• Higher wages (cost‑push) → firms raise prices.
• Higher prices → workers demand further wage increases (demand‑pull element).

The feedback loop can accelerate the overall inflation rate.

Policy Responses to Inflation (aligned with the syllabus)

1. Monetary Policy (AO2)

• Raise interest rates → reduces consumer borrowing and investment, curbing aggregate demand.
• Control the money supply (open‑market operations, reserve requirements).
• Evaluation: Effective against demand‑pull inflation but does little to lower production costs; may increase unemployment.

2. Fiscal Policy (AO2)

• Increase taxes or cut government spending to reduce disposable income and aggregate demand.
• Conversely, reduce indirect taxes (VAT, excise) to alleviate cost‑push pressures.
• Evaluation: Directly tackles cost‑push inflation when tax reductions target the specific input (e.g., fuel duties), but large fiscal adjustments can be politically difficult.

3. Supply‑side Policies (AO2)

• Improve productivity – investment in technology, training, and research.
• Deregulation and competition‑enhancing measures to lower business costs.
• Infrastructure development (transport, energy) to reduce logistical costs.
• Exchange‑rate management – foreign‑exchange interventions to stabilise the currency.
• Evaluation: Address the *underlying* cost pressures, so they are the most sustainable solution, but results are often long‑term and may require substantial upfront spending.

Data Set for Practice (AO2 – calculation of inflation)

Use the following CPI values to calculate the annual inflation rates. Show your working.

Questions:

1. Calculate the inflation rate for 2020 (using 2019 as the base year).
2. Calculate the inflation rate for 2021 (using 2020 as the base year).
3. Comment on the trend you observe.

Key Take‑aways

1. Inflation = sustained rise in the general price level; deflation = sustained fall.
2. Measured primarily by the CPI – a weighted, fixed‑basket price index; the CPI has a known limitation (substitution bias).
3. Two principal causes:

   • Demand‑pull: excess aggregate demand.
   • Cost‑push: rising production costs (wages, raw materials, exchange‑rate depreciation, indirect taxes, supply shocks).

4. Cost‑push inflation shifts the short‑run AS curve leftward, raising the price level while potentially lowering output.
5. Consequences affect consumers, workers, firms and government – from reduced purchasing power to fiscal pressures.
6. Policy responses are grouped into:

   • Monetary policy (interest rates, money supply)
   • Fiscal policy (taxes, spending, indirect‑tax adjustments)
   • Supply‑side policy (productivity, deregulation, infrastructure, exchange‑rate management)

7. Evaluation: monetary tightening curbs demand but may raise unemployment; fiscal measures can target cost‑push factors but are politically sensitive; supply‑side reforms are most durable but take time to materialise.