Cost Push Inflation

Definition

Cost push inflation occurs when the overall price levels rise due to increases in the costs of production, such as wages and raw materials. This type of inflation is driven by supply-side factors, meaning that when producers face higher costs, they pass these costs onto consumers in the form of higher prices, leading to a decrease in aggregate supply. This phenomenon highlights the relationship between production costs and overall economic inflation, indicating how external factors can lead to rising prices even in the absence of increased demand.

5 Must Know Facts For Your Next Test

1. Cost push inflation can be triggered by various factors, including rising wages, increased prices for raw materials, or supply chain disruptions.
2. When cost push inflation occurs, it can lead to stagflation, which is characterized by stagnant economic growth combined with high inflation and unemployment.
3. Central banks often struggle to combat cost push inflation because traditional monetary policy tools may not effectively address supply-side issues.
4. In times of cost push inflation, businesses may reduce production due to decreased profitability, further exacerbating the inflation problem.
5. Cost push inflation typically results in a leftward shift of the aggregate supply curve on the Phillips Curve, indicating higher prices and lower output.

Review Questions

• How does cost push inflation differ from demand pull inflation in terms of causes and effects?
  • Cost push inflation is caused by increases in production costs, such as wages and raw material prices, leading to higher overall prices. In contrast, demand pull inflation occurs when consumer demand exceeds supply, pushing prices up. The effects of cost push inflation can include reduced economic output and potential job losses due to higher production costs making it less profitable for companies to operate.
• Discuss how a sudden increase in oil prices could lead to cost push inflation in an economy.
  • A sudden increase in oil prices raises transportation and production costs across various industries. As companies face higher expenses for fuel and raw materials, they often pass these costs onto consumers by raising prices for goods and services. This results in cost push inflation as the overall price level rises while aggregate supply may decrease due to reduced profitability for businesses. The ripple effect can be felt throughout the economy, impacting consumer purchasing power and economic growth.
• Evaluate the implications of cost push inflation on monetary policy decisions made by central banks.
  • Cost push inflation presents significant challenges for central banks when setting monetary policy. Traditional approaches focus on managing demand through interest rate adjustments; however, if inflation is primarily driven by supply-side factors, such as rising production costs, increasing interest rates may not effectively control prices. In fact, higher rates could stifle economic growth further by reducing investment and consumption. Consequently, central banks must carefully assess the nature of inflation before implementing policies, often balancing the need to control rising prices with the risk of slowing down an already fragile economy.

Related terms

Demand Pull Inflation:

Inflation that arises when demand for goods and services exceeds their supply, leading to higher prices.

Aggregate Supply:

The total quantity of goods and services that producers in an economy are willing and able to sell at a given overall price level.

Producer Price Index (PPI): An index that measures the average changes in selling prices received by domestic producers for their output, often used as an indicator of inflation.