Answer to Question #92277 in Macroeconomics for Tshepo Mfisa

Question

Using the aggregate demand and supply analysis, explain with the aid of diagrams the
concept of (i) cost-push inflation and (ii) demand-pull inflation by assessing how the two
impact on the price level, real GDP and employment.

Answer 1

Cost Push Inflation

Cost push inflation occurs when there is a decrease in supply of goods and services. This happens when the cost of production increases and pushes the price level. The cost of production increases when there in increase in prices of the factors such as increases in wages, raw materials, indirect tax etc. When the companies are working at their optimum capacity, there cannot increase simply produce more and thus pass on the increased cost of production to the customers in terms of higher prices. The company passes the increased costs of production on to the consumer, making higher price levels.

Cost push inflation affects employment too because when there is a decrease in GDP, the demand for goods and services decreases, which then makes firms to lay off workers and decreasing the employment.

Causes of Cost Push Inflation

• Supply shock: If there is an increase in prices of essential goods like oil, this raises the transport costs and all firms would experience higher costs.
• Rising unit labour costs: Wages are a large share of costs for firms. Push for higher wages leads to an increase in costs of production for the firm and hence higher price level.
• Higher taxes: Higher indirect tax, VAT etc raises the costs and thus the price level.
• Rise in import costs: If there is depreciation in the exchange rate results in higher price of the imported goods.

Demand Pull Inflation

This occurs when there is a strong consumer demand i.e. inflation due to increase in aggregate demand for goods and services. In demand pull inflation, the increase in demand for goods, pulls up the price to rise and thus raising the inflation. Here, the aggregate demand of the economy outweighs the aggregate supply which makes the price level to increase.

In a market where there is high demand for goods, prices ought to go up. Demand-Pull Inflation is also termed as “too much money chasing too few goods”. The effect of inflation depends on how steep the AS curve is and how close it is to full employment.

Due to the increase of demand, firms tend to hire more people which eventually increase the output. Thus, firms hire more people, which increase employment. When people hold more money, this results in more demand for goods and services. And firms will try and hire more people to keep up with demand.

Causes of Demand Pull Inflation:

• Consumption: If there is an increase in consumption and investment by firms, this will raise AD.
• Exchange rate: Increase in price of imports and reduces the foreign price of a country's exports. If consumers buy less imports, then exports grow, AD in will rise.
• Government Spending: Increase in government spending will rise AD.
• Monetary growth: Excessive monetary growth raises the price of the good.