Reduced production costs are the best way to combat cost-push inflation. A supply-side policy is a good idea, but it will take a long time to take effect. Wage subsidies are something that the government can do. The government assists firms in this scenario by covering a percentage of labor costs.
What can be done to reduce cost-push inflation?
- Commodity prices are rising. A spike in oil prices would result in higher gasoline prices and transportation costs. Costs would rise for all businesses. Higher oil prices, being the most essential commodity, frequently lead to cost-push inflation (e.g. 1970s, 2008, 2010-11)
- Inflation caused by imported goods. Import prices will rise as a result of the depreciation. As a result of the growing cost of imports, we frequently see an increase in inflation following a devaluation.
- Wages that are higher. Wages are one of the most significant expenses for businesses. As businesses incur increased costs as a result of growing wages, prices will rise (higher wages may also cause rising demand)
- Taxes will be raised. The cost of goods will rise as VAT and excise charges rise. This price rise will only be temporary.
- Inflationary profit-push. If businesses develop more monopoly power, they will be able to raise prices in order to boost profits.
- Food costs are rising. Food accounts for a lesser percentage of overall spending in western economies, but it plays a larger importance in developing countries. (inflationary food)
A rise in the price of oil or other raw commodities could trigger cost-push inflation. Imported inflation can occur when the currency rate depreciates, raising the price of imported items.
Cost-Push Inflation Temporary or Permanent?
This graph depicts cost-push inflation in the United Kingdom between 2008 and 2011. Because the economy was in recession, these times of cost-push inflation were only brief.
Many cost-push causes, such as increased energy prices, greater taxes, and the impact of currency depreciation, may only be temporary. As a result, if greater inflation is caused by cost-push causes, central banks may be willing to tolerate it. In 2011, for example, CPI inflation hit 5%, yet the Bank of England kept interest rates at 0.5 percent. This indicated that the Bank of England believed there was little underlying inflationary pressure.
In 2011, CPI inflation reached 5%, however inflation was just 3% if we subtract the effect of taxes (CPI-CT). Inflation would have been much lower if we took out the effect of increasing import prices (due to depreciation).
Others may be concerned that transient cost-push factors would affect inflation expectations. People may bargain for greater salaries if they see higher inflation, and the temporary cost-push inflation becomes permanent.
There is evidence that transient cost-push inflation in the 1970s resulted in persistently greater inflation. Part of the reason for this is that workers requested higher salaries in reaction to rising prices.
Inflation was induced in the 1970s by a significant rise in oil costs, as well as growing nominal wages. Workers were able to demand higher wages because they had more negotiating power.
Measures of Inflation
Some inflation strategies aim to avoid ‘temporary cost-push forces.’ CPI-Y, for example, ignores the impact of taxes. The term “core inflation” refers to a method of measuring inflation that excludes volatile elements such as commodities and energy.
Policies to Reduce Cost-Push Inflation
Cost-push inflation policies are similar to demand-pull inflation strategies in that they both aim to reduce inflation.
The government might follow a deflationary fiscal strategy (more taxes and reduced spending), or the central bank could raise interest rates. This would raise borrowing costs while reducing consumer spending and investment.
The difficulty with employing higher interest rates is that, while they will cut inflation, they will also cause a significant drop in GDP.
For example, due to rising oil and food costs, we saw a significant period of inflation (5%) in early 2008. Central banks kept interest rates high, but the economy fell into recession as a result. Interest rates should have been lower, and less emphasis should have been placed on minimizing cost-push inflation, according to others.
We may witness a period of cost-push inflation in 2010, but the Central Bank may need to be more flexible in its inflation targets in 2010. If inflation is caused by transient circumstances, rigidly adhering to an inflation target is pointless.
Better supply-side measures that help to enhance productivity and shift the AS curve to the right could be the long-term solution to cost-push inflation. These policies, however, would take a long time to take effect.
How can cost-push and demand-pull inflation be managed?
The Central Bank and/or the government are in charge of inflation. The most common policy is monetary policy (changing interest rates). However, there are a number of measures that can be used to control inflation in theory, including:
- Higher interest rates in the economy restrict demand, resulting in slower economic development and lower inflation.
- Limiting the money supply – Monetarists say that because the money supply and inflation are so closely linked, controlling the money supply can help control inflation.
- Supply-side strategies are those that aim to boost the economy’s competitiveness and efficiency while also lowering long-term expenses.
- A higher income tax rate could diminish expenditure, demand, and inflationary pressures.
- Wage limits – attempting to keep wages under control could theoretically assist to lessen inflationary pressures. However, it has only been used a few times since the 1970s.
Monetary Policy
During a period of high economic expansion, the economy’s demand may outpace its capacity to meet it. Firms respond to shortages by raising prices, resulting in inflationary pressures. This is referred to as demand-pull inflation. As a result, cutting aggregate demand (AD) growth should lessen inflationary pressures.
The Bank of England may raise interest rates. Borrowing becomes more expensive as interest rates rise, while saving becomes more appealing. Consumer spending and investment should expand at a slower pace as a result of this. More information about increasing interest rates can be found here.
A higher interest rate should result in a higher exchange rate, which reduces inflationary pressure by:
In the late 1980s and early 1990s, interest rates were raised in an attempt to keep inflation under control.
Inflation target
Many countries have an inflation target as part of their monetary policy (for example, the UK’s inflation target of 2%, +/-1). The premise is that if people believe the inflation objective is credible, inflation expectations will be reduced. It is simpler to manage inflation when inflation expectations are low.
Countries have also delegated monetary policymaking authority to the central bank. An independent Central Bank, the reasoning goes, will be free of political influences to set low interest rates ahead of an election.
Fiscal Policy
The government has the ability to raise taxes (such as income tax and VAT) while also reducing spending. This serves to lessen demand in the economy while also improving the government’s budget condition.
Both of these measures cut inflation by lowering aggregate demand growth. Reduced AD growth can lessen inflationary pressures without producing a recession if economic growth is rapid.
Reduced aggregate demand would be more unpleasant if a country had high inflation and negative growth, as lower inflation would lead to lower output and increased unemployment. They could still lower inflation, but at a considerably higher cost to the economy.
Wage Control
Limiting pay growth can help to lower inflation if wage inflation is the source (e.g., powerful unions bargaining for higher real wages). Lower wage growth serves to mitigate demand-pull inflation by reducing cost-push inflation.
However, as the United Kingdom realized in the 1970s, controlling inflation through income measures can be difficult, especially if labor unions are prominent.
Monetarism
Monetarism aims to keep inflation under control by limiting the money supply. Monetarists think that the money supply and inflation are inextricably linked. You should be able to bring inflation under control if you can manage the expansion of the money supply. Monetarists would emphasize policies like:
In fact, however, the link between money supply and inflation is weaker.
Supply Side Policies
Inflation is frequently caused by growing costs and ongoing uncompetitiveness. Supply-side initiatives may improve the economy’s competitiveness while also reducing inflationary pressures. More flexible labor markets, for example, may aid in the reduction of inflationary pressures.
Supply-side reforms, on the other hand, can take a long time to implement and cannot address inflation induced by increased demand.
Ways to Reduce Hyperinflation change currency
Conventional policies may be ineffective during a situation of hyperinflation. Future inflation expectations may be difficult to adjust. When people lose faith in a currency, it may be essential to adopt a new one or utilize a different one, such as the dollar (e.g. Zimbabwe hyperinflation).
Ways to reduce Cost-Push Inflation
Inflationary cost-push inflation (for example, rising oil costs) can cause inflation and slow GDP. This is the worst of both worlds, and it’s more difficult to manage without stunting growth.
Demand-Pull inflation
When aggregate demand surpasses aggregate supply, demand-pull inflation occurs. This occurs when an increase in expenditure on goods and services outpaces the increase in economic output. When the money supply grows faster than the economy, demand-pull inflation develops, and the money is spent on goods and services. This causes the demand curve to move to the right, causing prices to rise at all levels of output.
As the economy expands, the money supply must expand in lockstep. Inflation occurs when the money supply rises too quickly, while deflation occurs when it grows too slowly. Inflation is determined not just by the supply of money stock, or the quantity of money, but also by how quickly people spend it, or the velocity of money. The velocity of money in an economy is simply the total value of all transactions divided by the total value of the money stock. Inflation is determined by both amount and velocity, yet the quantity of money is meaningless without velocity. For example, if Grandma wins a million dollars in the lottery, takes it as a lump sum payout, and then stuffs it in her huge mattress, the economy will be unaffected. It’ll be as if the money never existed in the first place. Because $1 million has been removed from circulation, the money supply really drops in this situation. This would cause the economy to contract, albeit in a tiny way for a $20 trillion economy.
Central banks can regulate the availability of credit and the money supply, but they can’t control how quickly people spend it. The cheap availability of credit can sometimes raise the money supply. During the period 2003-2007, one of the clearest examples of demand-pull inflation happened when real estate prices skyrocketed as banks began lending to anybody who could breathe. The mortgages were bundled into mortgage-backed securities, which the banks then sold to investors, transferring the mortgages’ credit default risk to them. This allowed the banks to take the mortgages off their balance sheets, allowing them to make even more loans, which they did because they benefitted from the loan origination and servicing costs. As a result of this continuous process, demand grew considerably faster than supply, resulting in demand-pull inflation.
There will be no demand-pull inflation as long as the increase in economic output exceeds the increase in the money supply. Increases in expenditure will induce enterprises to use up their idle capacity before raising prices as long as they have idle capacity. However, as the economy approaches full employment and idle capacity is depleted, boosting output without large additional investments becomes increasingly difficult, and prices rise. As the constraints of fixed capital and finite labor are approached, the marginal cost of more output rises dramatically, prompting enterprises to raise prices to cover the rising expenses and boost profits.
In general, some demand-pull inflation is a positive thing since it means the economy is getting closer to full capacity and the unemployment rate is returning to its natural level. This boosts economic growth and prosperity, which central banks aim to sustain by limiting the money supply to match the economy’s growth rate. This controls demand-pull inflation.
However, just raising the money supply may not always result in inflation, at least not in the short term. For example, if the wealthy receive the majority of the additional money, they are more likely to invest it in the stock market or acquire collectibles such as art. Prices for most products and services will not rise as a result of these investments, as measured by the CPI or the GDP deflator. Indeed, as the wealthy earn a higher percentage of economic wealth, less of that wealth is used to buy the goods and services that an economy produces, which helps to keep inflation at bay. The wealthy have a reduced marginal propensity to consume since they already own the majority of the products and services they desire. The rich, on the other hand, purchase status symbols such as pricey paintings or investments. In such circumstances, the values of collectibles or financial products, such as stocks, will rise faster than the CPI.
Monetary Policy and Demand-Pull Inflation
Demand-pull Because inflation is a monetary process, examining demand-pull inflation in terms of monetary variables is obvious. Aggregate demand is equal to the quantity of money multiplied by the velocity of money, and when aggregate demand grows faster than economic output, price levels must rise, resulting in inflation.
The following equation summarizes the link between the quantity of money (M), the velocity of money (V), aggregate pricing levels (P), and economic output (Y):
The basic goal of central bank monetary policy is to control inflation at a low level. By keeping the value of money relatively steady and inflation predictable, low inflation allows consumers and businesses to manage their money more effectively. Central banks, on the other hand, can only regulate the amount of money in circulation; they have no direct control over the velocity of money or economic activity.
In the short run, money’s velocity is variable. When interest rates fall, velocity tends to slow down, and when they rise, it tends to increase. However, this is unlikely to reflect causation, implying that changes in interest rates are caused by changes in velocity. Rather, velocity falls as the economy weakens, which occurs when the Federal Reserve (Fed) or central banks in other countries lower interest rates. When the economy is growing, velocity is high, and the Federal Reserve raises interest rates to slow it down. Because consumers had no money to spend when the Great Recession began in 2007, money velocity fell, and the Fed decreased interest rates to revive the economy. As a result, the economy’s slowdown resulted in lower money velocity and lower interest rates. Without this shared source, it would be more reasonable to expect lower interest rates to increase money velocity, given lower interest rates generally enhance consumption and capital investments by firms.
This drop in velocity also explains why, despite the Fed’s increased money supply, there was no inflation throughout the Great Recession. People were heavily in debt, and they were unable to spend any more money, causing businesses to be unable to sell their goods and services, forcing them to lay off employees. As a result, increasing the money supply does not always lead to higher inflation, especially in a slumping economy.
In the long run, however, the velocity of money is assumed to be constant, therefore an increasing money supply compared to economic growth leads to higher inflation.
Cost-Push inflation and Stagflation
Increases in the cost of economic inputs or sources of production can sometimes generate inflation, which is known as cost-push inflation. Cost-push inflation, on the other hand, is less common than demand-pull inflation, particularly in less developed countries, where politicians are more likely to handle monetary difficulties by printing more money, which is a primary cause of demand-pull inflation in those countries. As per-unit production costs rise, cost-push inflation emerges.
The entire input cost divided by the units of output equals the per-unit production cost.
Businesses want to make money, therefore if per-unit manufacturing costs rise, they will raise their prices, even if output and employment fall. Even when economic growth is moderate or even negative, this creates inflation. In other words, inflation can occur amid periods of economic stagnation, and stagflation is the term for it. Stagflation is a portmanteau of “stagnation” and “inflation,” with the first syllable of “stagnation” replaced by the last two syllables of “inflation.”
In the 1970s, for example, the price of imported oil nearly doubled in 197374 and then soared dramatically again in 197980. Supply shocks are large-scale sources of cost-push inflation.
It’s not always easy to tell the difference between demand-pull and cost-push inflation; in many cases, both are at work. Demand-pull inflation, on the other hand, will continue as long as the money supply grows, whereas cost-push inflation is self-limiting: higher prices lower demand when the money supply does not.
Output is reduced by cost-push inflation. Between 1973 and 1975, the Organization of Petroleum Exporting Countries (OPEC) quadrupled the price of oil, causing economic output to drop and the unemployment rate to rise from 5% in 1973 to 8.5 percent in 1975.
How can demand-pull inflation be kept under control?
Governments and financial organizations have a few measures at their disposal to keep inflation from spiraling out of control. To combat demand-pull inflation, a central bank can raise interest rates, causing consumers to spend less on housing and goods. As a result, demand falls, allowing producers to catch up with supply and restore equilibrium.
What factors can lead to cost-push inflation?
When the supply of an item or service changes but the demand for it does not, this is known as cost-push inflation. It usually happens when there is a monopoly, wages rise, natural disasters strike, regulations are enacted, or currency rates fluctuate. Cost-push inflation is a rare occurrence.
What does cost-push inflation look like?
The energy industry oil and natural gas prices is the most common example of cost-push inflation. You, like almost everyone else, require a certain amount of gasoline or natural gas to power your vehicle or heat your home. To make gasoline and other fuels, refineries require a particular amount of crude oil.
What causes cost-push inflation when a currency is devalued?
A currency devaluation lowers the value of the currency, making exports more competitive and imports more expensive.
Because of higher import costs and increased demand for exports, a devaluation is expected to contribute to inflationary pressures. The overall impact, however, is dependent on the status of the economy and other inflation-related factors.
1. Inflationary cost-push
Imported goods will be more expensive if the currency is devalued. Imports account for a large portion of the CPI, hence they will contribute to cost-push inflation.
It’s possible that shops will not pass on price hikes to consumers due to decreased profit margins, but prices will rise if the depreciation continues.
2. Inflation driven by demand
A devaluation is likely to result in a rise in AD. If exports are cheaper (AD = C+I+G+X-M), more exports will be sold, while imports will decrease. Higher AD will generate inflation if the economy is close to full capacity.
- A spike in AD will not produce inflation if the economy is in recession and there is spare capacity.
- There is unlikely to be demand-pull inflation if other components of AD are not increasing (e.g., consumer spending). (X-M isn’t the most important component of AD.)
- Also, if exports are cheaper, the effect on AD is determined by demand elasticity. If demand is inelastic, only a little increase in quantity will occur, and the value of exports may fall (the Marshall Lerner condition implies that devaluation raises AD only if PEDx + PEDm >1).
3. Companies have fewer incentives.
Third, depreciation makes exports more competitive (cheaper to overseas purchasers) without requiring much effort on the part of enterprises, thus there is less motivation for them to lower costs in the long run, resulting in higher costs and higher inflation. This may not occur, though, if businesses are well-run and have incentives to decrease costs.
When the UK departed the ERM in 1992, it weakened its currency dramatically, yet it did not produce inflation. This was due to the fact that the economy was in a slump and there was a lot of unsold inventory. This demonstrates that inflation is influenced by a variety of other things. However, in the 1950s and 1960s, the declining pound was frequently blamed for UK inflation.
This depreciation contributed to the UK’s inflation rate exceeding the government’s target of 2%.
However, the years 2008-12 were marked by recession and slow economic growth. Due to the economy’s very low demand, the devaluation had little effect on demand-pull inflation. The cost-push inflation of 2008 was very temporary.
Depreciation’s impacts were still adding to inflation in 2010/11. The MPC stated that devaluation was a contributing element to the UK’s cost-push inflation.
We would have seen a larger impact on inflation if the UK’s depreciation had occurred during a period of normal growth.
How can supply-side inflation be kept under control?
- Governments can fight inflation by imposing wage and price limits, but this can lead to a recession and job losses.
- Governments can also use a contractionary monetary policy to combat inflation by limiting the money supply in an economy by raising interest rates and lowering bond prices.
- Another measure used by governments to limit inflation is reserve requirements, which are the amounts of money banks are legally required to have on hand to cover withdrawals.
What is the impact of cost-push inflation on the economy?
Inflation is caused by four basic factors. Cost-push inflation, defined as a reduction in aggregate supply of goods and services due to an increase in the cost of production, and demand-pull inflation, defined as an increase in aggregate demand, are two examples. They are classified by the four sections of the macroeconomy: households, businesses, governments, and foreign buyers. An rise in an economy’s money supply and a reduction in the demand for money are two more elements that contribute to inflation.
Which of the following is the most accurate definition of cost-push inflation?
Definition: Inflation generated by an increase in the price of inputs such as labor, raw materials, and so on is known as cost push inflation. As the price of the factors of production rises, the supply of these commodities decreases. While demand remains constant, commodity prices grow, resulting in an increase in the overall price level. In essence, this is cost-push inflation.
Description: In this situation, the overall price level rises due to greater manufacturing costs, which are reflected in higher pricing of goods and commodities that rely heavily on these inputs. Inflation is triggered by the supply side, i.e. because there is less supply. Demand pull inflation, on the other hand, occurs when increasing demand causes inflation.
Other variables, such as natural disasters or depletion of natural resources, monopoly, government regulation or taxes, change in currency rates, and so on, could all contribute to supply side inflation. In general, cost push inflation occurs when there is an inelastic demand curve, which means that demand cannot easily adjust to rising costs.
Also see: Profit Margin, Wage Price Spiral, Aggregate Demand, and Demand-Pull Inflation.