Causes of inflation: cost-push

Published by Patrick Mutisya · 14 days ago

Government and the Macroconomy – Inflation: Cost‑Push Causes

Government and the Macroconomy – Inflation

Objective

Understand the causes of inflation, focusing on cost‑push inflation.

What is Cost‑Push Inflation?

Cost‑push inflation occurs when the overall price level rises because the costs of production increase, leading firms to raise their selling prices.

Key Causes of Cost‑Push Inflation

  • Rising Wages – Higher wage demands or statutory minimum‑wage increases raise labour costs.

  • Higher Raw‑Material Prices – Increases in the price of essential inputs such as oil, metals, or agricultural commodities.

  • Supply‑Side Shocks – Unexpected events that reduce the availability of key inputs (e.g., natural disasters, geopolitical tensions).

  • Exchange‑Rate Depreciation – A weaker domestic currency makes imported inputs more expensive.

  • Increased Indirect Taxes – Higher \cdot AT or excise duties raise production costs.

How Cost Increases Translate into Higher Prices

  1. Input costs rise.

  2. Firms face lower profit margins if they keep prices unchanged.

  3. To maintain profitability, firms increase the prices of their output.

  4. The aggregate price level rises, resulting in inflation.

Illustrative Example

Suppose the cost of oil, a major input for transport and manufacturing, rises by 20 %.

\$\$

\text{New Cost} = \text{Old Cost} \times (1 + 0.20)

\$\$

If the average firm’s total cost is composed of 30 % oil‑related expenses, the overall cost increase for the firm is:

\$\$

\Delta C = 0.30 \times 0.20 = 0.06 \; \text{or} \; 6\%

\$\$

To preserve profit margins, the firm may raise its product price by roughly 6 %.

Table: Common Cost‑Push Factors and Their Typical Economic Impact

FactorTypical SourceEffect on Production CostsPotential Inflationary Outcome
Wage IncreasesTrade unions, minimum‑wage legislationHigher labour expenses per unit of outputUpward pressure on consumer prices, especially in labour‑intensive sectors
Oil Price SpikeOPEC decisions, geopolitical eventsHigher transport and energy costs for most industriesBroad‑based price rises, often reflected in transport and food prices
Import‑Price Rise (Depreciated Currency)Exchange‑rate movementsMore expensive imported raw materials and intermediate goodsCost‑push inflation, especially in economies reliant on imports
Increased Indirect TaxesGovernment fiscal policyHigher tax burden on goods and servicesBusinesses pass tax through to final prices
Supply‑Side Shock (e.g., flood)Natural disaster, warReduced availability of key inputs, raising their market priceSudden price spikes in affected commodities

Interaction with Demand‑Pull Inflation

Cost‑push and demand‑pull inflation can occur simultaneously. When both aggregate demand and production costs rise, the overall inflation rate may accelerate, creating a “wage‑price spiral.”

Suggested diagram: Aggregate Supply (AS) curve shifting leftward from AS₁ to AS₂, leading to a higher price level (P₂) and lower real output (Y₂). Label the initial equilibrium as E₁ (P₁, Y₁) and the new equilibrium as E₂ (P₂, Y₂).

Policy Responses to Cost‑Push Inflation

  • Monetary Policy – Central banks may raise interest rates to curb demand, but this does not directly lower production costs.

  • Supply‑Side Policies – Improving productivity, reducing trade barriers, or investing in infrastructure can mitigate cost pressures.

  • Targeted Subsidies – Temporary subsidies for critical inputs (e.g., fuel vouchers) can ease price pressures, though they may strain public finances.

  • Exchange‑Rate Management – Interventions to stabilise the currency can limit import‑price inflation.

Key Take‑aways

  1. Cost‑push inflation originates from rising production costs, not excess demand.

  2. Common triggers include wage hikes, higher raw‑material prices, supply shocks, exchange‑rate depreciation, and increased indirect taxes.

  3. The resulting upward shift in the short‑run aggregate supply curve raises the price level while potentially reducing output.

  4. Policy measures focus on stabilising costs and improving supply‑side efficiency rather than merely curbing demand.