Cost-Push Inflation : Meaning, Causes, Examples and Measurement

What is Cost-Push Inflation?

Cost-push inflation occurs when the overall prices of goods and services increase due to rising production costs, including higher wages and raw material expenses. This type of inflation is prompted by elevated production costs, leading to a reduction in aggregate supply within the economy. Consequently, the heightened costs of production are transferred to consumers, resulting in cost-push inflation. Factors contributing to this inflationary pressure include increased costs of input goods, such as raw materials in manufacturing, and elevated labor expenses due to mandatory wage hikes or labor strikes. Natural disasters, government regulations, and changes in laws can also impact production costs and contribute to cost-push inflation.

Geeky Takeaways:

• Cost-push inflation occurs when overall prices rise due to increased production costs.
• Factors contributing to cost-push inflation include higher wages, rising raw material expenses, and external factors like natural disasters or government regulations.
• Inflation has both positive and negative effects, stimulating economic growth when moderate but eroding purchasing power and destabilizing the economy when high.
• Investments to beat inflation include gold, diversified stock portfolios, real estate, commodities, Treasury Inflation-Protected Securities (TIPS), equities in strategic sectors, savings bonds, and focusing on essential goods providers.

Causes of Cost-Push Inflation

1. Increase in Production Costs: Rising expenses associated with production inputs, such as raw materials and energy, directly impact the overall cost of manufacturing goods. For instance, if the price of crude oil increases, it can elevate transportation and production costs, subsequently leading to higher prices for consumers. This scenario puts pressure on businesses to maintain profit margins while navigating increased production expenditures.

2. Increase in Wages and Benefits: Businesses may adjust the prices of their products or services in response to demands for higher wages and benefits from workers. The escalation in labor expenses contributes to cost-push inflation, as it directly influences overall production costs. This dynamic highlights the delicate balance between labor compensation and pricing strategies for sustained economic equilibrium.

3. Increase in Taxes: Higher taxes imposed on businesses result in augmented production costs. Companies may pass on this additional tax burden to consumers by raising prices for goods and services, thereby contributing to cost-push inflation. The relationship between taxation policies and consumer affordability becomes a critical aspect influencing pricing dynamics.

4. Increase in Import Prices: A surge in the prices of imported goods can induce cost-push inflation by elevating the cost of production for goods and services reliant on those imports. This increase in import prices can translate into higher overall prices experienced by consumers. Global economic factors affecting import prices underscore the interconnectedness of economies and their impact on domestic inflation.

5. Decrease in Aggregate Supply: Cost-push inflation can be intensified by a reduction in the aggregate supply of goods and services. When supply diminishes while demand remains constant or increases, it leads to price hikes due to an imbalance between supply and demand levels. Managing the delicate equilibrium between supply and demand becomes crucial in addressing the root causes of cost-push inflation.

Example of Cost-Push Inflation

In the 1970s, the oil crisis served as a tangible illustration of cost-push inflation, particularly driven by the actions of the Organization of Petroleum Exporting Countries (OPEC). OPEC’s decision to limit oil production caused a substantial 400% surge in oil prices during this period. This sharp increase in oil prices directly impacted industries heavily reliant on oil and gas inputs, raising their production costs significantly. Faced with escalating costs, these industries had no choice but to increase the prices of their goods to maintain profitability. This real-world scenario vividly demonstrates cost-push inflation, where the spike in production costs, specifically the surge in oil prices orchestrated by OPEC, resulted in subsequent price hikes passed on to consumers across various sectors.

How is Inflation Measured?

1. Consumer Price Index (CPI): The CPI serves as a metric to track fluctuations in the average price of a set of goods and services regularly utilized by households. This index is pivotal in gauging the inflation rate within an economy, providing insights into how the cost of living evolves. It is widely used to assess changes in purchasing power and guide economic policies.

2. Producer Price Index (PPI): The PPI functions as a measure to assess alterations in the average prices that producers receive for their goods and services. This index is particularly valuable as it reflects changes in input costs, offering a glimpse into potential inflationary pressures within the production sector. Businesses often use the PPI to adjust pricing strategies and anticipate market trends.

3. Gross Domestic Product (GDP) Deflator: The GDP deflator serves as a tool to evaluate alterations in the overall price level of all final goods and services produced within an economy. Unlike other indices, the GDP deflator provides a comprehensive perspective on inflation, encompassing the entire economic landscape. It is a key indicator for policymakers to use to make informed decisions about economic stability and growth.

What causes Inflation?

1. Demand-Pull Inflation: Demand-pull inflation occurs when there’s a surge in the demand for goods and services, but the corresponding increase in supply falls short. In the short term, businesses struggle to scale production swiftly, resulting in a supply-demand imbalance that prompts price hikes. This phenomenon is driven by heightened consumer demand outpacing production capabilities, leading to an overall increase in prices. The mismatch between supply and demand dynamics puts upward pressure on prices as the market grapples with shortages, leading to an inflationary trend.

2. Cost-Push Inflation: Cost-push inflation arises not only from increased demand but also from rising production costs for businesses. This issue occurs when factors such as higher raw material or labor costs compel businesses to raise prices for their goods and services. If this cost increase affects a significant number of businesses, it can contribute to an overall escalation in prices and higher inflation rates. External factors impacting the cost of production, such as increased raw material prices, can have widespread effects on businesses and consumers alike.

3. Devaluation: Devaluation occurs when a currency loses value in comparison to other currencies, making imports more expensive and potentially leading to inflation. If a country’s currency, for example, the U.S. dollar, depreciates against another currency, like the euro, it takes more of the devalued currency to purchase the same amount of the stronger currency. This can result in increased costs for businesses that import goods, potentially leading to higher prices.

4. Rising Wages: The relationship between rising wages and inflation is subject to varying perspectives. While increased wages can empower workers with more spending money, some experts argue that this may lead to inflation. The rationale is that heightened demand for goods and services due to increased wages can prompt businesses to raise prices to offset higher production and labor costs. The debate on the connection between rising wages and inflation revolves around the potential consequences of increased consumer spending power.

5. Inflation Expectations: Inflation expectations can become a self-fulfilling prophecy. When companies and workers anticipate higher inflation, these expectations may drive behaviors that exacerbate the issue. Workers, fearing a higher cost of living, may demand higher wages. In turn, companies, anticipating increased costs, may raise prices to maintain profit margins. This cycle of expectations can lead to actual inflation rates rising. The psychological aspect of inflation expectations plays a crucial role. Anticipated increases in costs, whether from workers or companies, can trigger a chain reaction of behaviors that, when realized, contribute to rising inflation rates.

What is the Wage-Price Spiral?

The wage-price spiral, a concept in macroeconomics, describes a recurring cycle where wage hikes lead to higher prices, triggering subsequent wage increases and creating a self-reinforcing loop. This pattern is rooted in workers seeking higher wages to address the rising cost of living, prompting businesses to raise prices to offset increased labor expenses. The loop persists as elevated wages contribute to price hikes, fostering expectations for further increases. While historically prominent in the 1970s, various factors like reduced union influence, globalization, and automation have weakened the direct correlation between wages and prices in recent times. Though concerns about a wage-price spiral persist, some economists argue that the conditions for such a spiral are less prevalent today. The ongoing debate centers on whether rising wages and prices can escalate uncontrollably, potentially leading to unsustainable inflation. Recent fears of a wage-price spiral have emerged, particularly with significant wage increases, but historical data indicates that the risks are manageable, with instances of nominal wage growth coexisting with moderated consumer prices without spiraling out of control.

What Investments beat Inflation?

• Gold Investments: Investing in gold remains a traditional hedge against inflation, demonstrating an average annual gain of 9.48% over the past two decades, surpassing inflation rates. This precious metal is often sought after for its historical resilience in preserving wealth during inflationary periods.
• Stock Market Diversification: Diversified stock portfolios, exemplified by indices such as the S&P 500, have proven to generate returns that outpace inflation rates. Investing in stocks provides an avenue for wealth growth and serves as a strategy to counter the adverse effects of rising prices.
• Real Estate Opportunities: Real estate investments, especially in residential properties and Real Estate Investment Trusts (REITs), serve as robust hedges against inflation. These avenues offer stable returns that either keep pace with or outperform inflation rates, providing investors with a reliable means of preserving and growing their capital.
• Commodities Beyond Gold: Investing in commodities like raw materials and agricultural products emerges as a potent inflation hedge. Their prices tend to rise during inflationary periods, offering investors an opportunity to benefit from the tangible value of these essential resources.
• Treasury Inflation-Protected Securities (TIPS): Treasury Inflation-Protected Securities (TIPS) are government-backed bonds designed to safeguard investors from inflation risks. As the Consumer Price Index rises, the value of TIPS increases, providing an effective shield against the erosive effects of inflation.
• Equities in Strategic Sectors: Certain categories of stocks, including small-cap, dividend growth, consumer products, financial, energy, and emerging markets companies, have historically demonstrated resilience during inflationary times. These equities typically yield total returns that surpass inflation rates, making them attractive options for investors seeking stability.

Can You Beat Inflation with Gold?

Gold is often hailed as the go-to safeguard against inflation by many investors, yet the ongoing debate surrounding this notion reflects its unsettled status. Examining gold’s performance from April 1968 to June 2020, it demonstrated an average annual increase of 7.6%, translating to a 3.6% return when adjusted for inflation. However, its instability was evident in significant declines of 28% in 2013 and 12% in 2015, challenging the perception of gold as a firm security. The unpredictable nature of gold prices is influenced by various factors, including global currency movements, decisions made by the Federal Reserve and other central banks, and the erratic dynamics of supply and demand. Additionally, investing in gold poses unique challenges, such as the need for secure storage and incurring associated costs. Furthermore, the capital gains tax rates on selling gold after a year are higher than those for stocks and bonds, adding another layer of complexity to its investment landscape.

Is Inflation Always Bad?

Inflation, with its multifaceted impact, carries both advantageous and detrimental consequences. When inflation is moderate, it acts as a catalyst for economic growth, fostering increased spending and investment. This positive side of inflation helps stimulate economic activities, contributing to overall prosperity. However, the scenario takes a less favorable turn when inflation is high, as it undermines the purchasing power of individuals and introduces instability to the economy. The adverse effects of high inflation include a reduced ability to afford goods and services, which can lead to economic challenges. Striking a delicate balance becomes crucial, as the dual nature of inflation necessitates careful management to harness its beneficial aspects while mitigating potential drawbacks.

Difference between Cost-Push Inflation and Demand-Pull Inflation

Basis	Cost-Push Inflation	Demand-Pull Inflation
Definition	It occurs when overall prices rise due to increased production costs such as wages and raw materials, leading to a decrease in aggregate supply.	Arises when aggregate demand surpasses aggregate supply, resulting from an increase in overall demand for goods and services.
Causes	An increase in the cost of input goods, rising labor costs, higher taxes, increased import prices, and a decrease in aggregate supply contribute to cost-push inflation.	An expansionary economy, increased government spending, overseas growth, or rising consumer confidence leading to higher consumer spending can cause demand-pull inflation.
Examples	In 1973, OPEC’s oil production restriction caused oil prices to surge by 400%, leading to increased production costs and subsequent price hikes in oil-dependent industries, illustrating cost-push inflation.	Excessive demand for goods and services during economic expansion or increased government spending can cause demand-pull inflation, resulting in a scenario where too many dollars chase too few goods.
Fueled By	Cost-push inflation is fueled by increased production costs, whereas demand-pull inflation is driven by changes in consumer demand.	Cost-push inflation reduces aggregate supply due to higher production costs, while demand-pull inflation results from increased aggregate demand.
Outcomes	Cost-push inflation leads to price increases passed on from production costs.	Demand-pull inflation results in price hikes due to excess demand.

Cost-Push Inflation – FAQs

Give an example of demand-pull inflation.

A classic example of demand-pull inflation is observed during the holiday season. The heightened demand for a specific toy or video game leads to people eagerly standing in lines and competing to purchase the product, often at elevated prices.

Write an example of demand-pull inflation in India.

Notable instances of demand-pull inflation in India were evident during the pandemic, causing a surge in the prices of handwashes, hand sanitizers, and masks. The increased economic demand outpaced the supply capacity, resulting in higher prices for these essential items.

What are the primary effects of demand-pull inflation?

Demand-pull inflation brings about various effects, including elevated borrowing costs, a reduction in consumer purchasing power, and sustained inflationary growth. This occurs when the overall production capacity of the economy cannot match the rising demand for goods and services.

Why is 2% inflation good?

Maintaining a 2 percent inflation rate is considered beneficial as it prevents the inflationary cycle, where individuals rush to buy goods anticipating higher prices in the future. By keeping inflation at 2 percent, costs only need to rise modestly, curbing the risk of shortages and excessive price increases.