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Cost-push inflation refers to inflation caused by rising production costs. It can happen because the input costs, such as wages, raw materials, energy, and financial costs, become more expensive.
Rising costs force producers to raise the selling price of products or services to maintain profit margins. If only one or two companies raise prices, it might not cause inflation in the economy. Thus, to impact prices in general, rising input prices must have a broad escalation of many producers from various industries.
How it differs from demand-pull inflation
If cost-push inflation occurs because of an increase in production costs, then demand-pull inflation occurs due to the high demand for goods and services.
Increased aggregate demand can come from the increased money supply, higher government spending, increased household consumption, higher exports, and so on. These factors shift the aggregate demand curve to the right.
When the aggregate demand curve shifts to the right, it will stimulate the economy to produce above its potential level (known as the inflationary gap). In this situation, the unemployment rate falls below its natural level and causes upward pressure on the price level.
Causes of cost-push inflation
As explained earlier, this type of inflation occurs because production costs rise massively. That can occur due to:
- Increase in wages
- Increase in raw materials and energy prices
- Tax
- Devaluation
Wage
Labor costs usually cover the majority of production costs, especially in labor-intensive industries. When labor costs increase higher than productivity, it can reduce profit margins.
Pressure for wage increases is usually high when unemployment is low, and inflationary pressure is high. The labor market is tight as the supply becomes more limited to meet higher demand.
Due to the tight market, producers compete for qualified labor to increase output. As attractors, they tend to offer higher wages, which are likely to rise above normal levels.
At the same time, high inflation undermines the wages of existing workers. They then renegotiate wage increases to protect purchasing power. As a result, production costs rise, forcing producers to pass on the cost to selling prices, pushing up inflation.
Raw materials and energy
Rising raw materials and energy costs are major drivers of cost-push inflation. The most well-known culprit is a spike in oil prices. When oil prices go up, they affect transportation costs across the economy. This can lead to higher prices for everything from manufactured goods delivered by truck to agricultural products shipped by train.
Another factor is a disruption in the supply of raw materials. Natural disasters like floods, droughts, or extreme weather events can devastate harvests, leading to shortages of agricultural products like wheat and vegetable oils. With fewer raw materials available, their prices rise, pushing up production costs for food and other goods that rely on them.
Tax
Tax increases aren’t always straightforward. They can act as a hidden driver of cost-push inflation, particularly when it comes to import duties. These are taxes levied on goods coming into a country. Imagine a scenario where the government raises import duties on alcohol, cigarettes, and gasoline. This directly increases the cost of these products for businesses that import or sell them.
Businesses are stuck between a rock and a hard place. They can either absorb the extra cost, which hurts their profits or raise prices for consumers. In most cases, they’ll opt to raise prices. This directly leads to inflation for those specific imported goods, like alcohol, cigarettes, and gasoline, which impacts transportation costs across the economy.
But the story doesn’t end there. Higher transportation costs can have a ripple effect. Businesses that rely on trucks or trains to deliver their products may see their own costs rise. This could lead to price increases for a wider range of goods, from manufactured items to agricultural products. The domino effect can cause inflation to spread throughout the economy, even beyond the initially taxed goods.
It’s important to note that not all tax increases trigger cost-push inflation. However, import duties are a prime example of how tax policy can influence production costs and ultimately impact consumer prices.
Devaluation
A devaluation is a tool used by governments to weaken their own currency compared to foreign currencies. While it can boost exports by making them cheaper to sell abroad, it also has a hidden cost: inflation.
Let’s examine the two sides of this coin. On the positive side, devaluation makes a country’s exports more attractive to foreign buyers. Imagine a company selling furniture—if its currency weakens, the furniture becomes cheaper for overseas customers. This can lead to a surge in exports, which is good for economic growth.
However, there’s a catch. Devaluation also makes imports more expensive. This is because foreign goods now cost more in the devalued domestic currency. Businesses that rely on imported raw materials or machinery will see their production costs rise. The same goes for everyday items consumers buy, like electronics or clothing.
Faced with higher costs, companies have two choices: absorb the hit to their profits or raise prices for consumers. In most cases, they’ll raise prices to maintain their profit margins. This increase in prices across the board contributes to cost-push inflation.
Effects of cost-push inflation
Cost-push inflation doesn’t just make your wallet lighter, it can also hurt the overall economy. Here’s how:
Sticker shock: The most immediate effect is a jump in prices across the board. Remember how we mentioned higher production costs? Businesses can’t swallow those costs entirely, so they raise prices to maintain their profit margins. This can lead to inflation, where the value of your money decreases, and everyday goods become more expensive.
Shrinking supply: Cost-push inflation also throws a curveball at economic growth. When production costs rise, businesses may choose to produce less. This is because it becomes less profitable to make things at the same level as before. This shift in production is reflected in a leftward shift of the short-run aggregate supply curve. In simpler terms, the economy produces fewer goods and services (lower supply) at any given price level.
Stagflation threat: In the worst-case scenario, cost-push inflation can lead to stagflation. This scary economic term describes a situation where prices rise (inflation), but economic output falls (stagnation). This can happen if policymakers try to stimulate the economy (increase aggregate demand) to counter the production slow down. While this might bring output back up, it can also lead to even higher prices.
Solutions for cost-push inflation
If the government adopts more stringent policies, such as raising interest rates, inflation does decline, but real GDP will fall further and lead to recession. This policy hurts unemployment.
Conversely, if the government relaxes policies to stimulate aggregate demand, the output returns to its potential level, but inflation will rise even higher.
The right solution to cost-push inflation is to reduce production costs. A supply-side policy is a correct solution, but generally, it will take a long time to affect.
The government can provide wage subsidies. In this case, the government helps businesses by paying a portion of labor costs. Thus, production costs remain low and reduce incentives to increase selling prices.
Revaluation is also an alternative to reduce inflationary pressures on imported goods. This policy is beneficial, especially in countries where most of the production input comes from imports.
The latter is to increase economic productivity, for example, through improving labor skills and adopting more advanced technology. Increased productivity makes production more efficient, increasing output but at a lower cost.
