Demand-Pull and Cost-Push Inflation - Online Tutor, Practice Problems & Exam Prep

Inflation can arise from two main sources: demand-pull and cost-push. Demand-pull inflation occurs when increased consumer spending outpaces supply, leading to higher prices. Conversely, cost-push inflation results from rising production costs, which reduce supply and subsequently elevate prices. In both scenarios, the equilibrium shifts, causing inflationary pressures. Understanding these concepts is crucial for analyzing economic conditions and the impact on aggregate demand and supply.

Demand-Pull Inflation

All right. Now, let's see how inflation relates to our supply and demand graph. So inflation can be caused by both demand or supply: an increased demand or a decreased supply. On the demand side, we call it demand-pull inflation because the demand is pulling the prices upward. On the supply side, it's known as supply-push inflation where the supply is pushing prices upwards.

For demand-pull inflation, the concept is that there's too much spending, chasing too few goods. There's a lot of demand but not enough supply to match it, right? So in this case, the demand is pulling the price levels higher. If we hold production constant, assuming we can't increase the supply right now, and the supply remains constant while the demand grows, we will see the prices increase.

Let's go to our graph and review our standard market graph, where we've got our downward demand and our upward supply curves, labeled D1 and S1. We're going to say that demand increases here. There's so much demand in the market that the demand curve shifts to the right. When demand increases, we would have a new demand curve to the right.

What we would expect is for us to move to this new equilibrium, where our original equilibrium was right here. We would expect a new equilibrium right there. At our old equilibrium, we had Q₁; price P₁ here and the new equilibrium would have a higher quantity and a higher price. We would see an increase in prices because of this increased demand—that's normal. We would expect that.

But when inflation happens, well, guess what? We're going to hold the supply constant. The supply can't increase. We can't have an increase in quantity to match the increased demand. There's no more available output in our society or whatever. So, let's see how this affects things. Ideally, we would see a shift in the demand curve as described, but in reality, with the new demand, the equilibrium would shift. However, the quantity supplied can't extend past the original point. There's no way to meet the new demand, with the quantity supplied staying at the original point.

Thus, the demand on our new graph will be willing to pay a higher price for that level of supply. We would see this higher price level. I'll label this high price as pH for the high price willing to pay at that quantity of supply that's not able to increase. Notice what's happening: we had our equilibrium price down here, P* (star), and now, we've got inflated prices. Though this example was just to give you a visual illustration, in practice, you might only need to understand what demand-pull inflation is—the idea of increasing demand, but the supply can't meet it, so prices go up even though there is no increase in production.

The concept here dovetails into what we see in cost-push inflation, where costs are pushing the prices up. Let's discuss cost-push inflation next.

Cost-Push Inflation

Alright, so now let's try the same thing but with cost-push inflation. So what we saw with the demand-pull is the demand pulling the price upward. Here, the cost to the firms is pushing the price upward. Why is that? Well, the per unit costs are increasing. So for the firm, the cost of producing them is going up, causing the profits to fall. So with lower profits, well, guess what? People are going to leave the industry, and it's going to reduce output, right? There are fewer producers when there is less profit, and it's going to lead to a lower available supply. So in this case, let's hold demand constant, right? Before we were holding supply constant, let's hold the demand constant, but the supply falls. Well, just like we've been used to on our graph, we've got our demand, downward demand, upward supply, and now we have a decrease in supply. And notice what we call this here. We call this a supply shock, right? Because firms were anticipating certain prices for all their raw materials, and all of a sudden, there's an increase in these prices. Well, it's going to shock the supply and cause us to have a lower supply here. So we've got S_2, a lower supply, and just like we've been used to when we were first studying this graph, well, guess what? We had our original equilibrium there, and now our equilibrium moved over here. So what happened? We had our original Q_1P_1, price 1 and quantity 1, and now what happens with the supply shock? There's less available. So we have a lower quantity supplied, Q_2. Right? And now, the price level has increased because there's less available. The price increases to P_2. So again, we have inflation, right? We have increasing prices here, and this is because the cost-push supply, right? The supply lowered and it caused the price to increase. So we've seen a graph like this before. Pretty interesting. Nothing too much to understand here other than these are the causes of inflation. So when you see demand pull, well, it's pulling the price up, and cost push pushing the price up. So in both cases, it's up because we're talking about inflation, right? Prices going up. Alright. That's about it here. Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is demand-pull inflation and how does it occur?

Demand-pull inflation occurs when the overall demand for goods and services in an economy exceeds the available supply. This imbalance leads to higher prices. Essentially, too much money is chasing too few goods. For example, if consumer spending increases significantly but production remains constant, the increased demand will push prices up. This can be visualized on a supply and demand graph where the demand curve shifts to the right, leading to a new equilibrium with higher prices. Understanding demand-pull inflation is crucial for analyzing economic conditions and the impact on aggregate demand and supply.

What is cost-push inflation and what causes it?

Cost-push inflation occurs when the costs of production for goods and services increase, leading to a decrease in supply and higher prices. This type of inflation is often caused by rising costs of raw materials, labor, or other inputs. When production costs rise, firms may reduce output, leading to a lower supply of goods and services. On a supply and demand graph, this is represented by a leftward shift of the supply curve, resulting in a new equilibrium with higher prices. Cost-push inflation is important to understand as it highlights how production costs can impact overall price levels in an economy.

How do demand-pull and cost-push inflation differ?

Demand-pull and cost-push inflation differ primarily in their causes. Demand-pull inflation is driven by increased consumer demand that outpaces supply, leading to higher prices. This can occur due to factors like increased consumer spending, government expenditure, or investment. On the other hand, cost-push inflation is caused by rising production costs, such as higher prices for raw materials or wages, which reduce supply and push prices up. While both types of inflation result in higher prices, demand-pull inflation is demand-driven, whereas cost-push inflation is supply-driven.

What are the effects of demand-pull inflation on the economy?

Demand-pull inflation can have several effects on the economy. Initially, it may stimulate economic growth as higher demand encourages increased production and investment. However, if it persists, it can lead to overheating of the economy, where demand outstrips supply, causing sustained price increases. This can erode purchasing power, reduce savings, and create uncertainty in the economy. Central banks may respond by tightening monetary policy, such as raising interest rates, to curb inflation. Understanding these effects is crucial for policymakers and economists in managing economic stability.

How can cost-push inflation be controlled?

Controlling cost-push inflation can be challenging as it originates from rising production costs. One approach is to improve productivity and efficiency within industries to offset higher costs. Governments can also implement policies to stabilize prices of key inputs, such as subsidies or price controls. Additionally, central banks may use monetary policy tools, like raising interest rates, to reduce overall demand and ease inflationary pressures. However, these measures need to be carefully balanced to avoid stifling economic growth. Understanding these strategies is essential for managing inflation and maintaining economic stability.