Answer to Question #52842 in Macroeconomics for Ellie

Question

Distinguish between demand pull and cost push inflation. Why might it be difficult to establish the extent to which a given rate of inflation is demand pull or cost push?
(4 marks)

Answer 1

When there is a decrease in the aggregate supply of goods and services stemming from an increase in the cost of production, we have cost-push inflation. Cost-push inflation basically means that prices have been "pushed up" by increases in costs of any of the four factors of production (labor, capital, land or entrepreneurship) when companies are already running at full production capacity. With higher production costs and productivity maximized, companies cannot maintain profit margins by producing the same amounts of goods and services. As a result, the increased costs are passed on to consumers, causing a rise in the general price level (inflation).

Demand-pull inflation occurs when there is an increase in aggregate demand, categorized by the four sections of the macroeconomy: households, businesses, governments and foreign buyers. When these four sectors concurrently want to purchase more output than the economy can produce, they compete to purchase limited amounts of goods and services. Buyers in essence "bid prices up", again, causing inflation. This excessive demand, also referred to as "too much money chasing too few goods", usually occurs in an expanding economy.