- 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.
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 can be done to reduce demand-pull inflation?
Governments and central banks would have to undertake a tight monetary and fiscal policy to combat demand pull inflation. Increasing the interest rate, reducing government spending, or boosting taxes are all examples. Consumers would spend less on durable goods and homes if the interest rate were to rise. It would also raise corporations’ and businesses’ investment spending. Because Aggregate Demand D is rising too quickly in demand pull inflation, these contractionary actions would slow the rise, implying that inflation would still occur but at a slower rate.
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.
How may supply-side policies help to lower cost-push inflation?
Government initiatives aimed at increasing productivity and efficiency in the economy are known as supply-side policies. If successful, they will move aggregate supply (AS) to the right, allowing for stronger long-term economic growth.
- Free-market supply-side policies aim to boost competitiveness and efficiency in the market. Privatization, deregulation, lower income tax rates, and trade union influence are only a few examples.
- Government intervention is used in interventionist supply-side programs to counteract market failure. Increased government spending on transportation, education, and communication, for example.
Benefits of Supply-Side Policies
Supply-side measures, in theory, should boost productivity and move long-run aggregate supply to the right.
1. Decreased Inflation
A lower price level will result by shifting AS to the right. Supply-side reforms will help to reduce cost-push inflation by making the economy more efficient. Privatization, for example, may result in cheaper prices as a result of increased efficiency.
2. A Lower Rate of Unemployment
Supply-side measures can help to lower the natural rate of unemployment by reducing structural, frictional, and real wage unemployment. See also: Unemployment-reduction programs on the supply side.
3. An increase in economic growth
Supply-side policies will raise the long-run rate of economic growth by increasing LRAS, allowing for faster growth without producing inflation.
4. Trade and the Balance of Payments have improved.
Firms will be able to export more if they become more productive and competitive. This is critical in view of the heightened competition posed by a globalized marketplace. Also see: The Importance of Supply-Side Policies in the Economy.
Examples of supply-side policies
Privatization is number one.
Selling state-owned assets to the private sector is one example. The private sector, it is believed, is more effective in running enterprises because it has a profit motive to cut costs and improve services. More information on privatization can be found here.
2. Liberalization
This entails lowering entry barriers to allow new businesses to enter the market. The market will become more competitive as a result of this. In telecommunications, for example, BT used to be a monopoly, but now multiple companies fight for our business. Competition usually results in reduced prices and higher quality goods/services.
- The problem is that not every industry is open to competition. Power generating and water supply, for example, are natural monopolies. Privatization and deregulation of these industries often results in the formation of a private monopoly with the ability to charge greater prices.
3. Lowering personal income tax rates
Lower income tax rates, it is said, boost the incentives for people to work harder, resulting in increased labor supply and productivity. Similarly, lowering corporate taxes allows businesses to keep more profit and invest it.
- However, this isn’t always the case; lower taxes don’t always mean more work incentives (e.g. if income effect outweighs substitution effect). Firms may choose to give or save their higher profits rather than invest them. See also: Corporation Tax Cuts.
5. Liberalize the labor market
- Employers should find it easy to hire and terminate employees. Redundancy pay or the right to appeal should be abolished.
- Allow for zero-hour contracts, which allow businesses to hire people when demand is higher.
If it is less expensive to hire and fire employees, the theory goes, it will incentivize businesses to hire people in the first place, resulting in more job opportunities.
- More flexible labor markets, on the other hand, might lead to more uncertainty and reduced productivity. Also see: Labor Market Flexibility
5. Trade union power is being weakened.
This could include legislation that restricts trade unions’ power to strike. This should include the following:
Reducing unemployment benefits is number six on the list.
Lower unemployment payments may encourage unemployed people to work. Working-age people may be more motivated to work longer hours if their benefits are not means-tested.
7. Financial markets should be deregulated.
Building societies, for example, were allowed to become profit-making banks. More competition should result from deregulation, which should, in principle, cut borrowing rates for consumers and businesses.
7. Expand the free-trade zone
Lower tariff barriers will boost commerce and encourage export companies to invest. Non-tariff barriers are becoming increasingly relevant. The EU Single Market, for example, has harmonised laws, allowing for more seamless trade. Negotiating frictionless trade agreements can cut business costs and increase efficiency.
9. Eliminating needless bureaucracy
Firms may find it difficult to develop and invest in new capacity due to planning constraints. Reduced red tape and bureaucracy lowers expenses for businesses and fosters an atmosphere that encourages investment.
ten. Promote immigration
Whether it’s professional jobs like construction and engineering or low-skilled employment like fruit picking, free-movement of labor can help businesses fill labor shortages. Liberal immigration rules help businesses keep up with rising demand by making labor markets more flexible. This can help enterprises avoid wage inflation while also allowing them to expand their productive capacity.
Interventionist supply-side policies
1. Increased educational and training opportunities
Better education can raise AS while also increasing labor productivity. In a free market, education is frequently under-provided, resulting in market failure. As a result, the government may need to subsidize appropriate education and training programs in order to fill job openings.
- Government action, on the other hand, will cost money and will need increased taxes. It will take time to take effect, and the government may subsidize the incorrect types of training.
2. Improving infrastructure and transportation
When it comes to transportation, there is almost always some level of market failure – congestion and pollution. Government funding on better transportation linkages can assist alleviate traffic congestion and address this market failing. Improved transportation infrastructure lowers transportation costs and encourages businesses to invest. Bottlenecks in transportation on the road, rail, and air are frequently highlighted as a major stumbling block for the UK economy.
- However, increasing transportation capacity in a congested country like the UK, particularly in London, can be difficult.
3. Increase the number of inexpensive housing units
Building cheap council homes in pricey locations can help employees move and find jobs in those areas, minimizing geographic immobility. Firms may face labor shortages in places where housing has grown too expensive.
4. Better healthcare
Time lost due to illness can cost a company a lot of money. Spending on health care that improves a country’s health can boost labor productivity. Discouragement of bad habits might also improve one’s health. Taxes on cigarettes, alcohol, and sugar, for example, can help to minimize the expenditures of health care related with intoxication, obesity, and polluted environments.
Limitations of supply-side policies
- Productivity growth is mostly dependent on private enterprise and technical innovation trends. The government’s ability to hasten technological development and improvements in working procedures has a limit.
- Supply-side measures can have the opposite effect. Flexible labor markets, for example, may lower corporate expenses, but if they lead to job insecurity, workers may become demotivated, and labor productivity may stagnate. Because of more flexible labor markets, the UK has witnessed a decrease in structural unemployment since 2009, although productivity growth has been nearly static.
- In a recession, supply-side strategies are unable to address the underlying issue of a lack of aggregate demand.
- Time. The effects of all supply-side measures take a long time to manifest. Some policies, such as education spending, may not have a long-term impact on the economy.
Which of the following policies can help to lower inflation?
6. Who made the comparison between inflation and robbers?
Professor Brahmanand and Wakeel compared inflation to robbers in their explanation.
7. Who is the author of the book “How to Pay for Money?”
8. Deflation is the polar opposite of which of the following concepts?
Explanation: Inflation is defined as an increase in the price of things, whereas deflation is defined as a drop in the price of products.
9. In order to minimize inflation, which of the following measures is used?
Explanation: Cutting government spending reduces the supply of money in the economy, lowering inflation even further.
10. In India, what is the base year for evaluating wholesale prices index (WPI) inflation?
How can you get inflation 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 an example of cost-push inflation?
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 temporary cost-push inflation?
The extent to which transient cost-push factors lead to a persistent spike in underlying inflation is a fascinating subject right now.
Rising commodity prices, rising food prices, and higher taxes are all temporary cost-push issues. Because these items are frequently volatile, the increase is usually just transitory. The price hikes in the case of taxes are only for a year.
How Temporary Inflation Pressures Can Lead to Higher Permanent Inflation
Wage Push Factors are a set of factors that influence how much money you make. Workers may demand a salary raise in response to rising prices in order to maintain living standards. Wages are a significant determinant of inflation because if wages rise:
- Firms will incur higher costs, which they will pass on to customers in the form of higher pricing.
As a result, if trade unions are successful in negotiating higher wages, momentary cost-push inflation could lead to a wage-price spiral and long-term inflation.
Expectations. Inflation expectations may vary if prices rise in a year. According to the adaptive expectations model, people’s expectations for future inflation are influenced by current inflation. As a result, if prices rise temporarily, individuals and businesses may mistakenly believe that inflation is increasing permanently. As a result, anticipating increased inflation will result in higher wages and prices.
Monetary policy’s credibility. People may lose faith in the Bank of England’s ability to keep inflation low if the Bank of England continues to claim that inflation is only temporary and will go shortly.
Temporary Inflation May Not Cause Permanent Inflation
Capacity Reserve It is easier for unions to secure wage increases in response to temporary inflation when unemployment is low and the economy is growing briskly. It’s tough to get pay increases when the economy is in a slump and unemployment is high, despite greater inflation.
Unions’ Strength Trade unions were more powerful and had more clout in the 1970s. They were successful in obtaining greater wages through collective bargaining. Unions, on the other hand, have less bargaining power in the UK economy.
The graphs below show how the 2008 inflation jump in the US and Europe did not result in greater core inflation.
In the 1970s, cost-push forces contributed to a wage-price spiral, resulting in a considerable increase in underlying inflation. However, in the current environment of high unemployment, weak unions, and slow development, it’s difficult to imagine salaries spiraling out of control.
Unfortunately, this means that many people’s living conditions are likely to deteriorate as headline inflation outpaces nominal wage growth.
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.