AS Macro Revision: Cost Push Inflation

This revision blog focuses on some of the causes of cost-push inflation. Cost-push inflation occurs when firms respond to rising costs, by increasing prices to protect their profit margins. There are many reasons why costs might rise:

Component costs: e.g. an increase in the prices of raw materials and other components used in supplying goods and services. This might be because of a rise in commodity prices such as oil, gas, copper and agricultural products used in food processing. A good recent example is the surge in the world price of wheat partly driven by rising demand for biofuels as a source of fuel.

Rising labour costs - caused by wage increases, which are greater than improvements in productivity. Wage costs often rise when unemployment is low because skilled workers become scarce and this can drive pay levels higher wages might increase when people expect higher inflation so they bid for higher pay in order to protect their real incomes. For most businesses, labour costs are the most significant part of their total operating costs, most notably in labour-intensive industries such as hotels, catering and retailing.

Expectations of inflation are important in shaping what actually happens to inflation! When people see prices are rising for the everyday items they purchase they start to get concerned about the effects of inflation on their real standard of living. One of the dangers of a pick-up in inflation is what the Bank of England calls “second-round effects” i.e. an initial rise in prices triggers a burst of higher pay claims as workers look to protect their way of life.

Higher indirect taxes imposed by the government – for example a rise in the specific duty on alcohol and cigarettes, an increase in fuel duty or a rise in Value Added Tax. Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers.

A fall in the exchange rate – this can cause cost push inflation because it normally leads to an increase in the prices of imported products. In recent years there has been a sizeable depreciation in the value of the pound sterling against both the Euro and the US dollar. This has brought about an increase in the costs of imports adding to the headline rate of inflation.

Cost-push inflation such as that caused by a large and persistent rise in the world price of crude oil can be shown in a diagram by an inward shift of the short run aggregate supply curve. The fall in SRAS causes a contraction of national output together with a rise in the level of prices.

Many of the causes of cost-push inflation come from external economic shocks – e.g. unexpected volatility in the prices of commodities and movements in the exchange rate.

A country can also import cost-push inflation from another country that is suffering from rising inflation of its own.

Cost-push inflation happens when costs have risen independently of demand