Saturday, August 22, 2009

Difference between Demand-pull Inflation and Cost-push Inflation

INFLATION
In ordinary sense inflation mean a general rise in prices. A rise in prices is the indication of inflation. Basically inflation represents a situation whereby the aggregate demand for goods and services exceeds the available supply of output. As Fisher defines “The inflation rate is the percentage rate per period that prices are increasing”. Keynes says “Any rise in price level after the level of full employment has been achieved” is inflation. According to Kent “Inflation is nothing more than a sharp upward movement in the price level”.
DEMAND-PULL INFLATION
Basically, inflation represents a situation whereby the pressure of aggregate demand for goods and services exceeds the available supply of output (both being counted at the prices ruling at the beginning of a period) in such a situation, the rise in price level is the natural consequence. Now this excess of aggregate demand over supply may be the result of more than one force at work. As we know aggregate demand is the sum of consumer’s spending on current goods and services, government spending on current goods and services and net investment being contemplated by the entrepreneurs. At times, however the government, the entrepreneur or the households may attempt to secure a large part of output than would thus accrue to them. Inflation is thus caused when aggregate demand for all purpose-consumption, investment and government expenditure-exceeds the supply of goods at current prices. This is demand pull-inflation.
COST-PUSH INFLATION OR WAGE INDUCED INFLATION
We can visualise a situation where even though here is no increase in aggregate demand, prices may still rise. This may happen if costs particularly the wage costs go on rising. Now as the level of employment rises, the demand for workers also rises so that the bargaining position of the workers becomes stronger. To exploit this situation, they may ask for an increase in wage rates which are not justifiable on grounds either of a prior rise in productivity or of cost of living. The employers in a situation of high demand and employment are more agreeable to concede these wage claims because they hope to pass on these rises in costs to the consumers in the shape of rise in prices. If this happened we have another inflationary factor at work and the inflation thus caused is called the wage induced or cost-push inflation.
WAGE-PRICE SPIRAL
But that will not be the end of the story. A rise in prices reduces the real consumption of wage earners. They will therefore pres for higher money wages to compensate themselves for the higher cost of living. Now an increase in wages, if granted, will raise the cost of production and therefore entrepreneurs will be tempted to raise the prices. This adds to the inflationary fire. A further rise in prices raises the cost of living still further and the workers ask for still higher wages. In this way wages and prices chase each other and the process of inflationary rise in prices gathers momentum. If unchecked this may lead to hyper-inflation which signifies a state of affairs where wages and price chase each other at a very quick speed. This is a state of galloping inflation. Thus inflation starts with aggregate demand for goods and services exceeding the supply there of (demand induced inflation) and it is further fed and strengthened by rising cost through wage-price spiral (cost induced inflation). There is increase in money supply without a corresponding increase in production so that there is case of too much money chasing too few goods.

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