Table of Contents
- Its effects
- Causes of cost-push inflation
- The difference between cost-push inflation Vs. Demand-pull inflation
- Solutions for cost-push inflation
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.
To maintain profit margins, rising costs force producers to raise the selling price of products or services. If only one or two companies raise prices, it might not cause inflation in the economy. Thus, to have an impact on prices in general, rising input prices must have a broad escalation of many producers from various industries.
Higher production costs cause an increase in the price level and shift the short-run aggregate supply curve to the left. As a result, real GDP contracted.
Usually, policymakers want to get out of the situation. To increase real GDP, they then adopt a loose policy, for example, by lowering interest rates.
When interest rates are low, aggregate demand should increase. Businesses and households can apply for new loans cheaper. Households then use new loans to buy goods and services, especially durable goods. Meanwhile, businesses use it to order capital goods. An increase in household consumption and business investment raises aggregate demand.
The increase in aggregate demand ultimately increases the level of general prices. Increased aggregate demand will stimulate production and bring the economy back to its level of potential output. However, note that this will cause a further rise in the price level.
One of the cost-push inflation risks is stagflation, where output falls, but the price level rises.
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
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, and force producers to pass on to selling prices, pushing up inflation.
Raw materials and energy
An increase in oil prices is the most common example of the cause of cost-push inflation. Another factor is the lack of raw material supply, which is usually caused by natural disasters. The latter is typical for agricultural products such as wheat and vegetable oils.
Tax increases, such as the import duty on alcohol, cigarettes, and gasoline, make production costs higher. Suppliers can pass on the tax burden to consumers.
Devaluation occurs when the government decreases the value of the domestic currency against foreign currencies. When this happens, exports become more competitive because they are cheaper.
Conversely, the price of imported goods becomes more expensive, both for raw materials and capital goods. The increase in the prices of those products ultimately increases production costs and forces producers to raise their selling prices.
The difference between cost-push inflation Vs. 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.
Sources of 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.
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. And 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 by reducing 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 of 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. Output increases but at a lower cost.