Causes and Effects of Demand-Pull and Cost-Push Inflation

This assignment discusses the causes and effects of demand-pull and cost-push inflation in an economy. It explains how demand-pull inflation occurs when aggregate demand exceeds aggregate supply, leading to economic growth and higher prices. On the other hand, cost-push inflation occurs when firms' productivity decreases, resulting in higher production costs and lower supply. The assignment also explores the causes of demand-pull and cost-push inflation, such as increased consumer income and taxes. Additionally, it examines the impact of factors like improved marketing skills, personal income tax, exports, and destruction of capital stock on economic activity and prices. Finally, it discusses the advantages and disadvantages of using the Consumer Price Index (CPI) to measure prices and the effects of inflation on different parties in an economy.

Running head: ASSIGNMENT 1
ASSIGNMENT
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Date

ASSIGNMENT 2
Question3
a.
Demand-pull inflation occurs when an economy’s aggregate demand is more than the
aggregate supply (Godin & Lane, 2013). Therefore the economy experiences an imbalance in
aggregate demand and supply and hence the market equilibrium under the AD-AS model is
distorted. This type of inflation occurs as the economy grows on the other hand. This is because
as aggregate demand increases, total consumption in the economy increases as well and hence
more output is produced to meet the rising demand. The increase in demand at a faster pace as
compared to supply leads to much income in the form of money by consumers chasing only a
few commodities which do not satisfy consumers fully. As the aggregate demand increases, the
production level in the economy reaches its optimal point where no more goods and services can
be produced to satisfy consumer high demand. When the economy reaches this point, the
aggregate demand curve shifts towards the right direction from point AD0 to AD1 and this leads
to economic growth as the total output increases from Q0 to Q1 while the market prices from P0 to
P1 leading to demand-pull inflation in the economy as indicated in the diagram below.

ASSIGNMENT 3
Cost-push inflation in a nation’s economy occurs when the nation’s aggregate supply
decreases. It usually occurs when firms operating in the economy exceed their productivity
beyond the optimum production volume (Totonchi, 2011). Contrary to demand-pull inflation,
cost-push inflation is coupled with a decline in a nation’s economic growth. Production of firm’s
above the optimum production point increases the production costs for firms and hence their
productivity for any production above the optimal point leads to a decline in their profitability
(Beullens & Janssens, 2011). The decrease in the firms’ profits leads to a decrease in supply as
the firms reduce their supply towards a production and supply point which yields higher profits.
This leads to a shift in the nation’s aggregate supply curve towards the left direction from AS0 to
AS1 and this leads to a decline in economic growth as total output produced decreases from Q0 to
Q1 whilst the market prices increase from P0 to P1 leading to cost-push inflation as indicated in
the below diagram.

ASSIGNMENT 4
b.
Causes of Demand-Pull Inflation
Demand-pull inflation may result from an increase in consumer level of income. When
consumers have more income with them, then they tend to spend more. This is because of the
increase in demand for goods and services which results from increased consumer expenditure.
Due to high consumption, aggregate demand in the economy increases more than the aggregate
supply. As a result, the price for goods and services increases leading to demand-pull inflation.
Demand-pull inflation may also result from the expectations of consumers of prices in the
market to increase in the future. If consumers anticipate a rise in prices in the future, they
purchase more goods and services to avoid the future expected costs which may result from the

ASSIGNMENT 5
increased prices. The higher consumption increases the aggregate demand more than the
aggregate supply and hence market prices increase leading to demand-pull inflation.
Causes of Cost-Push Inflation
Cost-push inflation may result from an increase in taxes by the government. If taxes are
increased such as corporate taxes, VAT, excise duties and other various business taxes, this leads
to a rise in firms’ production costs. Firms pass this burden to the final consumer by increasing
the prices for final goods and services and this causes cost-push inflation.
Cost-push inflation may also result from a supply shock. An economy experiences supply
shock if the prices for crucial commodities such as oil are increased by a big margin. For
example, if there is a drastic increase in the price of oil, then the cost incurred by firms in the
transportation of goods and services increases. Also, firms which use oil in production as a factor
input will experience a rise in the cost of factors of production. The increased price, therefore,
increases the production costs for firms and hence they increase the prices for their final
commodities leading to cost-push inflation.
Question5
a.
When the skills of firm managers in marketing and selling are improved, then they are
able to create significant awareness about the firms’ goods and services. They are also able to
convince more customers to purchase more goods and services offered by the firms. This
increases the demand for the firms’ products and hence the aggregate demand increases as firms
make more sales which improve their profitability. The increase in aggregate demand has to be

ASSIGNMENT 6
met by increased productivity by firms. The increase in aggregate demand leads to a shift in
aggregate demand curve towards the right direction from AD0 to AD2. This leads to an increase
in a nation’s economic activity as the quantity demanded increases from Q0 to Q1. The market
prices, on the other hand, rise from P0 to P1 as indicated in the below diagram.
b.
Personal income tax refers to taxes which are levied on personal income earned by
individuals in an economy (Gordon & Kopczuk, 2014). An increase in personal taxes reduces
personal income and consequently the consumers’ income available for consumption
expenditure. This makes consumers to reduce their consumption in accordance with their level of
income. The reduction in consumer expenditure reduces the demand for products in the economy
and hence the aggregate demand declines. The aggregate demand curve shifts towards the left
direction from point AD0 to AD1. As a result, the economic activity declines as the quantity of

ASSIGNMENT 7
output demanded decreases from Q0 to Q1. On the other hand, the prices prevailing in the market
decrease from P0 to P1 as indicated in the below diagram.
c.
Exports refer to goods and services produced by a nation and sold to other nations
through international trade (Cassiman, Golovko & Martínez-Ros, 2010). An increase in exports
generates more revenue for a nation and enables the nation to have a favorable balance of trade.
When exports increase, then it means that firms have to increase their productivity in order to
meet the demand arising from increased exports (Amiti & Weinstein, 2011). This increases the
aggregate supply and therefore the aggregate supply curve shifts towards the right direction from
AS0 to AS1. As a result, the economic activity is improved as the quantity of output produced
increases from Q0 to Q1. The market price, on the other hand, increases from P0 to P1 as indicated
in the diagram below.

ASSIGNMENT 8
d.
In the context of economics, the capital stock in an economy refers to equipment, plant and other
various assets which aid in the production of goods and services. The destruction of a nation’s
capital stock resulting from war leads to a decrease in supply as firms’ capital stock for
production is not available in sufficient amounts. The aggregate supply decreases and this leads
to a shift in the economy’s aggregate supply curve towards the left side from point AS0 to AS1.
This leads to a decline in the nation’s economic activity as the quantity of output produced
decreases from Q0 to Q1. On the other hand, the prices prevailing in the economy increase from
P0 to P1 as indicated in the below diagram.

ASSIGNMENT 9
Question6
a.
Advantages of Using the Consumer Price Index in Measuring Prices
Consumer price index gives an indication of the nation’s level of inflation (Nakamura,
Nakamura & Nakamura, 2011). If the yearly percentage of CPI is noted to increase then it means
inflation is higher while if the yearly percentage is noted to decrease then it means inflation has
decreased. This enables the manipulation of the nation’s monetary policy towards the desired
inflation level as indicated by CPI.
CPI enables a nation’s government to easily budget its expenditure on programs which
aim at benefiting its citizens. The level of income of a nation’s citizens is revealed by the CPI
and hence the government can determine the amount of its expenditure which should be
allocated for assisting its people.

ASSIGNMENT 10
Disadvantages of Using the Consumer Price Index in Measuring Prices
The quality of goods and services in the basket used in price measurement is not
considered by the CPI. This may give wrong information about price increase which may in
accordance with the increase in quality of goods and services since this should not be termed as
price increase as it’s matched with the increased quality.
The inflation rate of a nation may be overstated by the CPI. This is due to the fact that the
measurement does not put into consideration various factors such as the advancement of the
nation’s level of technology. Therefore wrong inflation information may be obtained as inflation
may have occurred due to the advancement of the nation in terms of productivity which should
actually not be termed as inflation rate increment.
b.
Inflation actually results in either a gain or loss considering various parties affected by
inflation within an economy. This happens due to the mismatch of payments made or received
and the prevailing inflation level within an economy (Bryan, 2013).
Some people in the economy gain from inflation. A good example is the borrowers and
other people who make fixed payments as a settlement for their debt. This is because they pay
their debts at the previous fixed interest rates which are not actually adjusted to match the current
level of inflation. Therefore they actually make lower payments in a real sense considering the
nation’s inflation level.
Other people in the economy lose from inflation. Good examples are those who earn
income which is fixed and those who lend money in the economy. People who earn income

ASSIGNMENT 11
which is fixed such as those depending on pension payments suffer when inflation occurs. This is
because they continue to earn fixed income which is not adjusted to match with the current
inflation. Therefore their living standards will decline as they can consume less using their
income as compared to the previous period. Money lenders, on the other hand, end up receiving
their lent money using the previous fixed interest rates which do not match the current inflation
rate. Therefore they end up losing in a real sense as what they receive is not as valuable as it was
in the previous period.
Question7
a.
No. when government securities are sold to banks then they use the money available for
lending to purchase the securities. This reduces the money supply in the economy.
b.
Yes. When interest rates fall, then people and businesses borrow more money for
investment and use in various activities as the costs of borrowing money decrease. This increases
the money supply in the economy.
c.
Yes. When the government is financed by the banking sector to increase its expenditure,
then it means that the government spends in improving various existing projects within the
economy and coming up with new projects aimed at improving the nation’s economic growth.
This leads to money supply growth in the economy.

ASSIGNMENT 12
d.
Yes. When the Central Bank of a nation purchases government securities from the
banking sector, then more cash is availed to banks for lending. The banking sector lends more
money to people and businesses and this leads to money supply growth in the economy.
e.
No. In order for the target inflation to be reduced then it means that the nation’s monetary
policy has to be tightened by the Reserve Bank by increasing interest rates or the cash rates
(Sawyer, 2010). The increase in interest rates will lead to a reduction in borrowing as money
borrowing costs rise and this will reduce money supply growth in the economy.
Question8
a) “Imports of goods”.
b) “Exports of services”. Purchase of insurance cover by overseas residents is an export of
insurance service.
c) “Capital transfers sent overseas from the nation”.
d) “Investment in the nation from overseas”.
e) “Short-term financial outflows”.
f) “Other income inflows”.
g) “Drawing on reserves”.
h) “Short-term financial inflows”.
i) “Adding to reserves”.
j) “Exports of goods”.

ASSIGNMENT 13

ASSIGNMENT 14
References
Amiti, M., & Weinstein, D. E. (2011). Exports and financial shocks. The Quarterly Journal of
Economics, 126(4), 1841-1877.
Beullens, P., & Janssens, G. K. (2011). Holding costs under push or pull conditions–The impact
of the Anchor Point. European Journal of Operational Research, 215(1), 115-125.
Bryan, M. (2013). The great inflation. Federal Reserve History, 12-13.
Cassiman, B., Golovko, E., & Martínez-Ros, E. (2010). Innovation, exports and
productivity. International Journal of Industrial Organization, 28(4), 372-376.
Godin, B., & Lane, J. P. (2013). Pushes and pulls: Hi (S) tory of the demand pull model of
innovation. Science, Technology, & Human Values, 38(5), 621-654.
Gordon, R. H., & Kopczuk, W. (2014). The choice of the personal income tax base. Journal of
Public Economics, 118, 97-110.
Nakamura, A. O., Nakamura, E., & Nakamura, L. I. (2011). Price dynamics, retail chains and
inflation measurement. Journal of Econometrics, 161(1), 47-55.
Sawyer, M. (2010). Phillips’ curve, independence of central banks and inflation targeting.
In Macroeconomics, Finance and Money (pp. 126-138). Palgrave Macmillan, London.
Totonchi, J. (2011). Macroeconomic theories of inflation. In International Conference on
Economics and Finance Research (págs. 459-462). Singapore: IACSIT Press.