Lesson 9 of 14 · free to read
Demand-pull inflation occurs when demand exceeds supply, while cost-push inflation arises from rising production costs, and both are tracked using the consumer price index and producer price index.
Many people think inflation is just one thing: prices going up. But there are two distinct causes, and knowing which one is driving prices matters for how you respond.
The idea
Inflation has two causes—demand-pull and cost-push—and is measured by the CPI and PPI, which track different price levels.
Inflation is not a single phenomenon. Economists distinguish two types based on what triggers the price rise.
Definition
Cost-push inflation
Triggered by increases in production costs, such as expenses for materials and wages; these increases push up the prices of final goods and services.
Higher costs of making things push prices up from the supply side.
Worked example
Consider a union wage negotiation:
The United Auto Workers negotiates a three-year contract raising wages 3% per year and increasing overtime pay.
This raises the carmakers' labor costs.
Carmakers raise car prices to cover the higher labor costs.
They pass the increased production cost on to buyers.
The higher wages give autoworkers more money to spend, increasing demand for other goods and services.
This added demand may pull up other prices.
Workers in other industries demand higher wages to keep up with rising prices.
This starts a wage-price spiral that pushes prices even higher.
A cycle where wages and prices chase each other upward.
Easily confused
Both types of inflation show up as rising prices, so it can seem like they are the same thing.
Demand-pull inflation is driven by excess demand ('too much money chasing too few goods'), while cost-push inflation is driven by rising production costs like wages and materials.
The cause determines the cure: demand-pull calls for cooling demand, cost-push calls for addressing cost increases.
To track inflation, economists use price indexes that measure changes in the cost of a fixed set of items.
Vocabulary· 2 terms
The CPI sets prices in a base period at 100. The base period, now 1982–1984, is chosen for price stability. Current prices are expressed as a percentage of base-period prices. A rise in the CPI means prices are increasing. For example, the CPI was 244.5 in April 2017, meaning prices more than doubled since the base period. The PPI uses 1982 as its base year and includes indexes for crude goods, intermediate goods, and finished goods. Because the PPI measures prices paid by producers for raw materials and energy, it may foreshadow later price changes for businesses and consumers.
Which type of inflation is at work when a union wage increase leads to higher car prices?
Inflation has several negative effects. It penalizes people on fixed incomes: a couple receiving $2,000 a month in 2018, with 10% inflation in 2019, can buy only about 91% (100 ÷ 110) of what they could in 2018. Inflation also hurts savers, as the real value of savings deteriorates.
How does inflation affect someone living on a fixed income?
Recap
Say each point to yourself, then tap it to check.
Cost-push: rising production costs push prices up.
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Adapted from Introduction to Business, © 2018 OpenStax, Rice University
Lawrence J. Gitman, Carl McDaniel, Amit Shah, Monique Reece, Linda Koffel, Bethann Talsma, and James C. Hyatt
Licensed under CC BY 4.0. This course is an adaptation, not the original work.
Access for free at openstax.org/details/books/introduction-business