Cost-push inflation

Inflation is defined as a sustained rise in the average level of prices, and, consequentially, a fall in the purchasing power of money.

Inflation is one of the core macro-economic problems identified by economists, and the stabilisation of prices is commonly regarded as the most important economic policy objectives.

Cost-push inflation is one of several possible types of inflation, identified by analysing the underlying cause of price rises. The other main type of inflation is demand-pull inflation.

Cost-push inflation occurs when production costs rise and are passed on to the consumer in price rises.

Sub-categories of cost-push inflation include:

1. 'Wage-push' inflation, where increases in wages are passed on in price rises, and;
2. Imported cost-push inflation, where domestic costs rise as a result of rising costs of imported resources, or from a fall in the exchange rate of a country.

As with all inflation, price changes are measured by the use of a price index, such as the CPI (Consumer Price Index), which tracks changes in the average prices of a basket of goods and services.

Why are costs passed on in price rises?

Several factors come into play when considering whether cost increases are passed through to consumer prices:

1. Firstly, cost increases need to be 'general' and not just limited to a few firms. For example, a fall in the exchange rate of an economy will affect all imported prices, and consequently the impact on domestic prices.
2. Similarly, increases in oil prices have a very 'general' effect as oil is widely used as a fuel and raw material for a range of products, including plastics.
3. Also, wage rises will have a general effect across an economy, especially as a result of the 'catch-up' process that might be triggered when one group of workers receive a pay rise.
4. Finally, the extent of competition in the micro-economy will have a bearing on the extent to which costs find their way into prices. The more competitive the market, the less likely that a rise in costs will be passed on to consumers - the more likely reaction is that firms will look to make productivity and efficiency improvements in the face of cost increases.

When the cost increases are significant, they are referred to as a cost 'shock', or more specifically a wage shock an oil shock, or a currency shock.

Cost-shocks can arise from many sources, including:

1. Sustained increases in wage costs above productivity increases.
2. Increases in the prices of commodities, such as oil and grains.
3. Increases in farm prices as a result of poor harvests.
4. A fall in the exchange rate, which increases the price of all imports.

Illustrating cost push inflation

The effect of a rise in costs can be illustrated through the use of an aggregate demand-supply diagram.

Assuming a constant price level, a cost shock will shift the short run aggregate supply curve (SRAS or AS) to the left. This is because the higher input costs mean less can now be produced - a reduction in costs would mean that more can be produced. For example, when oil prices increased during the oil shocks of the 1970s many manufacturing firms were forced to cut back on production as they could not afford to pay the inflated fuel and transport costs. Steel manufacturing¹ was particularly affected in the US between 1973 and 1975 as a result of the earlier oil shocks.

 Assuming the economy is currently operating at price level P, with real output at Y, and equilibrium at 'e', a cost shock will shift the AS curve to AS1. The result of this is that national income will now be in equilibrium at the higher general price level of P1, and the lower level of real output, at Y1. Aggregate demand will contract from 'e' to 'a'.

Cost increases shift the aggregate supply curve to the left, with the price level rising to P¹, and real output falling to Y¹.

The oil shocks of the 1970s triggered cost-push inflation across most of the developed world. By 1975, annual inflation peaked at just under 25% in the UK, and just under 12% in the US.

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Stagflation

Sustained cost shocks can contribute to a situation of recession occurring at the same time as inflation - called stagflation.

Historically, rising oil prices have often been at the centre of periods of stagflation, with the 1970s experiencing both high unemployment and inflation levels.

Following the oil shocks of the mid-1970s, unemployment in the UK, US and Canada, and most other developed economies took off in the late 1970s, peaking (in this cycle) at around 12% for the UK and 8% for the US.

US and UK stagflation in the 1970s

US stagflation

UK stagflation

Endnotes

1. US 'steel crisis' - https://en.wikipedia.org/wiki/Steel_crisis