by Cost-push inflation is a type of inflation caused by substantial increases in the cost of important goods or services where no suitable alternative is available. Higher prices are then the result, as costs of production increases due to a decreased aggregate supply. It stands in contrast to demand-pull inflation. Both accounts of inflation have at various times been put forward with oftentimes inconclusive evidence as to which explanation is superior.
Cost-push inflation occurs when we experience rising prices due to higher costs of production and higher costs of raw materials. Cost-push inflation is determined by supply-side factors, such as higher wages and higher oil prices.
Cost-push inflation is different to demand-pull inflation which occurs when aggregate demand grows faster than aggregate supply.
Cost-push inflation can lead to lower economic growth and often causes a fall in living standards, though it often proves to be temporary.
A situation that has been often cited of this was the oil crisis of the 1970s, which some economists see as a major cause of the inflation experienced in the Western world in that decade. It is argued that this inflation resulted from increases in the cost of petroleum imposed by the member states of OPEC.
Since, petroleum is so important to industrialized economies, a large increase in its price can lead to the increase in the price of most products, raising the price level. Some economists argue that such a change in the price level can raise the inflation rate over longer periods, due to adaptive expectations and the price/wage spiral, so that a supply shock can have persistent effects.
Causes
- Higher Price of Commodities. A rise in the price of oil would lead to higher petrol prices and higher transport costs. All firms would see some rise in costs. As the most important commodity, higher oil prices often lead to cost-push inflation (e.g. 1970s, 2008, 2010-11)
- Imported Inflation. A devaluation will increase the domestic price of imports. Therefore, after a devaluation, we often get an increase in inflation due to rising cost of imports.
- Higher Wages. Wages are one of the main costs facing firms. Rising wages will push up prices as firms have to pay higher costs (higher wages may also cause rising demand)
- Higher Taxes. Higher VAT and Excise duties will increase the prices of goods. This price increase will be a temporary increase.
- Profit-push inflation. If firms gain increased monopoly power, they are in a position to push up prices to make more profit
- Higher Food Prices. In western economies, food is a smaller % of overall spending, but in developing countries, it plays a bigger role.
Policies to Reduce Cost-Push Inflation
Policies to reduce cost-push inflation are essentially the same as policies to reduce demand-pull inflation.
The government could pursue deflationary fiscal policy (higher taxes, lower spending) or monetary authorities could increase interest rates. This would increase the cost of borrowing and reduce consumer spending and investment.
The problem with using higher interest rates is that although it will reduce inflation it could lead to a big fall in GDP.
For example, in early 2008, we had a high period of inflation (5%) due to rising oil and food prices. Central banks kept interest rates high, but this pushed the economy into recession. Arguably, interest rates should have been lower and less importance attached to reducing cost-push inflation.
In 2010, we might see a period of cost-push inflation, but, the Central Bank may need to adopt a certain flexibility in inflation targeting. There is no point in rigidly sticking to an inflation target if the inflation is caused by temporary factors.
The long-term solution to cost-push inflation could be better supply-side policies which help to increase productivity and shift the AS curve to the right. But, these policies would take a long time to have an effect.
