Theory 2 - Theories - Causes - Inflation - Monetary Policy - Economics bank - Virtual Bank of Biz/ed

Monetary Policy - Inflation - Causes

Theory 2 - Cost-push inflation - is inflation pushy?

Cost-push inflation happens when costs increase independently of aggregate demand. It is important to look at why costs have increased, as quite often costs are increasing simply due to the economy booming. When costs increase for this reason it is generally just a symptom of demand-pull inflation and not cost-push inflation. For example, if wages are increasing because of a rapid expansion in demand, then they are simply reacting to market pressures. This is demand-pull inflation causing cost increases.

However, if wages rise because of greater trade union power pushing through larger wage claims - this is cost-push inflation. Cost-push inflation is shown on the diagram below. The aggregate supply curve shifts left because of the cost increase, therefore pushing prices up.

The aggregate supply curve shifts left because of the cost increase, therefore pushing prices up.

So why might costs get pushed up, causing inflation? There are a number of possible sources of rising costs.

Wages

If trade unions gain more power, they may be able to push wages up independently of consumer demand. Firms then face higher costs and are forced to increase their prices to pay the higher claims and maintain their profitability.

Profits

If firms gain more power and are able to push up prices independently of demand to make more profit, then this is considered to be cost-push inflation. This is most likely when markets become more concentrated and move towards monopoly or perhaps oligopoly.

Imported inflation

We now work in a very global economy and many firms import a significant proportion of their raw materials or semi-finished products. If the cost of these increases for reasons out of our control, then once again firms will be forced to increase prices to pay the higher raw material costs. This could happen for several reasons:

  • Exchange rate changes - if there is a depreciation in the exchange rate, then our exports will become cheaper abroad, but our imports will appear to be more expensive. Firms will be paying more for their overseas raw materials.
  • Commodity price changes - if there are price increases on world commodity markets, firms will be faced with higher costs if they use these as raw materials. Important markets would include the oil market and metals markets.
  • External shocks - this could be either for natural reasons or because a particular group or country has gained more economic power. An example of the first was the Kobe earthquake in Japan, which disrupted world production of semi-conductors for a while. An example of the second was when OPEC forced up the price of oil four-fold in the early 1970s.

Exhaustion of natural resources

As resources run out, their price will inevitably gradually rise. This will increase firms' costs and may push up prices until they find an alternative source of raw materials (if they can). This has happened with fish stocks. Over-fishing has put many types of fish and fish-based products under extreme pressure, forcing their price up. In many countries equivalent problems have been caused by erosion of land when forests have been cleared. The land quickly becomes useless for agriculture.

Taxes

Changes in indirect taxes (taxes on expenditure) increase the cost of living and push up the prices of products in the shops. An example would be when the level of VAT was increased from 8% to 15% in the 1979 Budget. Many saw this as a one off change in prices rather than triggering inflation in its true sense, i.e. a general increase in the price level. The RPIY measure of inflation takes out the effect of indirect tax changes to get a clearer picture of the true level of inflation.