Q&A: AD and Inflationary Pressures

A student asks: Will a rise in AD will only cause cost-push inflation if there is a positive output gap?

A: There is a slight confusion evident in this question.

Demand pull inflation occurs when aggregate demand and output is growing at an unsustainable rate leading to increased pressure on scarce resources and a positive output gap. When there is excess demand in the economy, producers are able to raise prices and achieve bigger profit margins because they know that demand is running ahead of supply. Typically, demand-pull inflation becomes a threat when an economy has experienced a strong boom with GDP rising faster than the long run trend growth of potential GDP. The last time this happened to any great extent in the UK economy was in the late 1980s. It was not really a cause of the sharp rise in consumer price inflation in 2007-08.

Demand-pull inflation is likely when there is full employment of resources and aggregate demand is increasing at a time when SRAS is inelastic.

Cost-push inflation occurs when firms respond to rising costs, by increasing prices to protect their profit margins. Cost-push inflation can be illustrated 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.

The two causes of inflation are inter-related.

When the economy is experiencing very strong growth this can lead to supply bottlenecks resulting in increased prices for raw materials and components. There might also be upward pressure on wages (labour costs) especially if firms are having to bid up wages to attract extra staff or pay their overtime to stretch production to meet rising demand.

Here are some related blog posts on inflation