Answer to Question #15068 in Macroeconomics for jouj

Question

Why might it be difficult to establish the extent to which a given rate of inflation is demand pull or cost push?

Answer 1

Demand-pull inflation arises when aggregate demand in an economy outpaces aggregate supply.
It involves inflation rising as real gross domestic product rises and
unemployment falls, as the economy moves along the Phillips curve. This is
commonly described as "too much money chasing too few goods". More accurately,
it should be described as involving "too much money spent chasing too few
goods", since only money that is spent on goods and services can cause
inflation. This would not be expected to persist over time due to increases in
supply, unless the economy is already at a full employment level.

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. 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
inflation rate. This can raise the normal or built-in inflation rate, reflecting
adaptive expectations and the price/wage spiral, so that a supply shock can have
persistent effects.

Austrian school economists such as Murray N. Rothbard and monetary economists such as
Milton Friedman argue against the concept of cost-push inflation because
increases in the cost of goods and services do not lead to inflation without the
government and its central bank cooperating in increasing the money supply. The
argument is that if the money supply is constant, increases in the cost of a
good or service will decrease the money available for other goods and services,
and therefore the price of some those goods will fall and offset the rise in
price of those goods whose prices have increased. One consequence of this is
that monetarist economists do not believe that the rise in the cost of oil was a
direct cause of the inflation of the 1970s. They argue that although the price
of oil went back down in the 1980s, there was no corresponding
deflation.

Keynesians argue that in a modern industrial economy, many prices are sticky downward or
downward inflexible, so that instead of prices falling in this story, a supply
shock would cause a recession, i.e., rising unemployment and falling gross
domestic product. It is the costs of such a recession that likely causes
governments and central banks to allow a supply shock to result in inflation.
They also note that though there was no deflation in the 1980s, there was a
definite fall in the inflation rate during this period. Actual deflation was
prevented because supply shocks are not the only cause of inflation; in terms of
the modern triangle model of inflation, supply-driven deflation was counteracted
by demand pull inflation and built-in inflation resulting from adaptive
expectations and the price/wage spiral.