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.
How does the government attempt to keep cost-push 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.
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.
How do you deal with inflation caused by demand?
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 effects does cost-push inflation have?
Furthermore, cost-push inflation has an impact on employment since a reduction in real GDP reduces demand for products and services, forcing businesses to lay off workers and cut work. Living standards fall as a result of this form of inflation.
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.
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.
What is tutor2u’s definition of cost-push inflation?
When firms respond to growing unit costs by raising prices to defend their profit margins, this is known as cost-push inflation. Costpush inflation can be caused by both internal and external factors, such as a drop in the external value of the currency rate, which leads to an increase in the price of imported goods.
Explain what cost-push inflation is using a diagram.
ADVERTISEMENTS: ADVERTISEMENTS: ADVERTISEMENTS: ADVERTISEMENTS: AD We can imagine scenarios in which prices grow despite no increase in aggregate demand. This could happen if costs rise in the absence of any increase in aggregate demand.
What causes profit inflation?
2. Inflationary Profit-Pushing:
To clear the market, the explanation of direct profit-push inflation is limited to prices that are administratively fixed rather than market-determined. Businesses are expected to add a’mark-up’ factor to their labor and material costs per unit of production in the manner of equation P = W/x (1 + R), (14.3) to earn a target rate of return while setting ‘managed pricing.’
All oligopolistic enterprises or firms with some market strength in their respective industries are said to engage in such price fixing. When mark-ups or profit margins are pushed up without any rise in costs or demand, the resulting price increase is known as profit-push inflation.
Following the lead of a few prominent firms, other firms in the economy with some market power tend to mark-up their profit margins, partly to follow the lead of leading firms and partly because their material costs may have increased due to inter-industry interactions.
To distinguish it from the ‘wage wage spiral,’ the rate of such price increases has been dubbed the ‘profit-profit spiral.’ Because even competitive enterprises will discover that their cost curves have gone up, necessitating a drop in output, which is also accompanied by higher prices, the inflationary process might spread to other sections of the economy where prices are market-determined.
On various occasions, the above model has been called into doubt. First, the full-cost pricing approach, often known as “mark-up pricing,” does not explain how the “mark-up factor” is calculated. Furthermore, it is maintained that the so-called mark-up factor is never constant, but rather a variable that fluctuates with market demand conditions.
How do you figure out the inflation rate?
Last but not least, simply plug it into the inflation formula and run the numbers. You’ll divide it by the starting date and remove the initial price (A) from the later price (B) (A). The inflation rate % is then calculated by multiplying the figure by 100.
How to Find Inflation Rate Using a Base Year
When you calculate inflation over time, you’re looking for the percentage change from the starting point, which is your base year. To determine the inflation rate, you can choose any year as a base year. The index would likewise be considered 100 if a different year was chosen.
Step 1: Find the CPI of What You Want to Calculate
Choose which commodities or services you wish to examine and the years for which you want to calculate inflation. You can do so by using historical average prices data or gathering CPI data from the Bureau of Labor Statistics.
If you wish to compute using the average price of a good or service, you must first calculate the CPI for each one by selecting a base year and applying the CPI formula:
Let’s imagine you wish to compute the inflation rate of a gallon of milk from January 2020 to January 2021, and your base year is January 2019. If you look up the CPI average data for milk, you’ll notice that the average price for a gallon of milk in January 2020 was $3.253, $3.468 in January 2021, and $2.913 in the base year.
Step 2: Write Down the Information
Once you’ve located the CPI figures, jot them down or make a chart. Make sure you have the CPIs for the starting date, the later date, and the base year for the good or service.