Question

10. Use the model of aggregate demand and aggregate supply to show the differences between demand-pull inflation and cost-push inflation.

Answer 1

Inflation in any economy or market, is said to happen, when the general price level of the country rises beyond a certain threshold. Then, people can consume lesser of the item as it is expensive to purchase. For example, in the United States, the general level of inflation is considered to be 2% per year, though some degree of variation is considered normal, but if the inflation level goes up to 5%, then it is a serious cause of concern for the economists in the country.

Inflation is of the following two types and is described in length as follows: -

1) Demand Pull Inflation: -

When the general demand for goods and services in an economy is high, primarily because of higher availability of funds or in general if people find a product more attractive or needful and start purchasing the same in higher volumes, it causes a demand pull inflation. For example, during the recent Corona Virus outbreak, it became more essential for consumers to purchase face masks and sanitizers because of which their prices shot up and there was unexpected surge in buying volumes leading to inflation in these markets.

The following graph would help in understanding the concept in further detail: -

In the above graph, we see that the demand curve slopes downwards indicating that with a reduction in price the quantity demanded goes up. In this case however, the demand curve shifts towards the right and the Initial Equilibrium of Demand and Supply changes to Increased Equilibrium, the prices rise, from Initial Price to Increased Price, which further indicates inflation in the economy.

2) Cost Push Inflation: -

Cost push inflation on the other hand, takes place in the economy, primarily when the cost of manufacturing an item goes higher or the supplier cannot produce now in equal quantity due to supply related reasons such as shortage of raw materials, Higher wages demanded by workers etc. This leads them, to increase the price and reduce the supply of goods in circulation in the market.

The following diagram will further explain the same: -

In the above diagram, we see that the Quantity Supplied in the market decreases and the Initial Quantity is now the Reduced Quantity, post a shift in the supply curve.

Key Difference: -

Here, we can conclude that demand pull inflation takes place, as consumers begin to demand more products and services and has nothing to do with cost of operations. Even though, suppliers try their best to increase production and profits, beyond a point production increase is not possible and any addition to the demand then, would mean price hikes.

Further, Cost push Inflation takes place in an economy, wherein there is a supplier shortage, primarily because of rising costs of operations or lower raw material availability. As the product is less in supply, with demand remaining stable, the prices increase leading to inflation in the economy.

Thus, while one focuses on increase in demand, the other happens due to reduction in supply respectively.

Please feel free to ask your doubts in the comments section.