Politics & Society

What Is the Difference Between Cost-Push Inflation and Demand-Pull Inflation?

Written by MasterClass

Jun 26, 2019 • 3 min read

Understanding how inflation works is crucial to understanding the ebbs and flows of the global economy. There are two primary types of inflation: cost-push inflation and demand-pull inflation.

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What Is inflation?

Inflation is when a currency experiences a drop in value over time. Minor inflation is normal and a natural byproduct of a healthy economy. When inflation grows too quickly, money loses value at a quick rate and an entire economy can spiral out of control. Countries fight inflation through government regulation and adjustments to the monetary policies of central banks.

What Is Cost-Push Inflation?

Cost-push inflation is when prices rise as a result of rising costs of production and raw materials. Cost-push inflation is usually more temporary than other sorts of inflation and therefore central banks are more likely to leave interest rates alone if the cause of a high inflation rate is deemed to be cost-push. Some economists argue that short-term cost-push inflation often leads to long-term high inflation down the line, triggered by wage increases that come in response to the initial bout of cost-push inflation.

Learn more about cost-push inflation here.

What Are the Causes of Cost-Push Inflation?

  • Supply shock: A supply shock is a sudden rise in the price of essential commodities. For example, a sudden rise in the price level of oil can trigger higher costs of production or transportation for companies across all economic sectors. Every sector of the economy depends on oil either directly or indirectly. If OPEC were to drastically hike oil prices, it would cause higher prices for companies across the board and could trigger cost-push inflation.
  • Higher wages: As wages rise for workers, companies often adjust prices of goods to keep profit margins up. With higher costs keeping pace with higher wages, the economy is at risk of entering what’s called a wage price spiral. Price increases spur on wage increases at an exponential rate and the value of currency drops as more is needed to purchase goods.
  • Imported inflation: When trade partners experience inflation, some inflation can transfer over through imports. As an example, let’s say Japan underwent a period of inflation. When the United States imports Japanese goods, they are at an inflated overall price level which in turn can inflate other prices in the United States if enough imports are sold.
  • Higher taxes: Increases in indirect taxes like sales tax and excise duties can also lead to inflation by forcing prices up. When value added taxes or duties are applied to products, it leads to price inflation, and the consumer ends up shouldering some of the added tax burden.

What Is Demand-Pull Inflation?

Demand-pull inflation is a type of inflation that occurs when aggregate demand grows rapidly, outpacing aggregate supply. When demand soars above supply, this leads to prices rising to increase profits. Demand-pull inflation usually occurs when the economy is at almost full employment levels. Keynesian economics holds that when the economy reaches full employment during a period of economic growth, general price levels will skyrocket to maximize profits, which in turn will cause inflation.

Learn more about demand-pull inflation here.

What Are the Causes of Demand Pull Inflation?

  • Consumption: If consumption and investment rise drastically in an otherwise healthy economy, aggregate demand will rise. This causes prices to rise despite no change in the costs of production.
  • Exchange rate: A dramatic decrease in a country’s exchange-rate will cause import prices to rise and export prices to drop. Very quickly, consumers will stop buying imports while exports continue to rise. This leads to a rise in aggregate demand and causes inflation.
  • Government spending: Surges in government spending can also push up aggregate demand. This might occur during a government stimulus. If too much money is invested into the economy too quickly, aggregate demand will jump, which is one of the primary causes of inflation.
  • Expectations: Sometimes simply the expectation of inflation can itself lead to demand-pull inflation. Companies will raise prices to keep pace with perceived inflation, which will end up causing inflation.

How Can Inflation be Combatted?

In order to fight inflation, governments tighten up their monetary policy by increasing interest rates and reining in government spending. In the United States, the Federal Reserve raises interest rates during healthy economic periods, in order to prevent demand-pull inflation down the line. Prudent fiscal policy during periods of economic strength, is important to balance consumer spending and stave off inflation.

Learn more about economics and society in Paul Krugman’s MasterClass.