Causes and Effects of Demand-pull and Cost-push Inflation

This document discusses the causes and effects of demand-pull and cost-push inflation in the economy. It explains how demand-pull inflation occurs when aggregate demand outpaces aggregate supply, and how cost-push inflation occurs when aggregate supply decreases due to increased production costs. The document also explores the factors that contribute to each type of inflation. Additionally, it examines the impact of inflation on different parties, such as borrowers and lenders, and explains how inflation can be managed through monetary policies.

Running head: SEMISTER ASSIGNMENT 1
SEMISTER 1 ASSIGNMENT B
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SEMISTER ASSIGNMENT 2
Question3
a.
Demand-pull Inflation
Demand-pull inflation usually results in an economy when the economy’s aggregate
demand outpaces the aggregate supply (Totonchi, 2011). A few goods available in the economy
which can’t adequately satisfy consumer wants are chased by a lot of money held by consumers.
As this type of inflation occurs, the economy actually grows. As the consumer demand increases
in the economy, businesses increase their productivity and hence hire more workers to produce
extra goods and services. The total output in the economy increases as the unemployment rate
decreases. However, producers eventually reach their maximum production point where further
production leads to decreased profits. At this point, the economy is said to at its peak and full
employment is attained. Businesses therefore avid further production and as a result the
aggregate demand outpaces the aggregate supply and this leads to an increase in the market
prices in the economy causing demand-pull inflation as indicated in the below graph.

SEMISTER ASSIGNMENT 3
As illustrated in the graph, an increase in consumer demand increases the aggregate
demand in the economy. As a result, the aggregate demand curve shifts to the right direction
from AD to AD’. The real gross domestic product in the economy increases from Y1 to Y2
indicating a growth of the economy. The prices in the economy increase from P1 to P2 leading to
demand-pull inflation as illustrated.
Cost-push Inflation
An economy experiences cost-push inflation when there is a decrease in its aggregate
supply (Smaghi, 2009). Aggregate supply decreases due to an increase in firms’ production
costs. The rise in production costs may result from the increase in costs for factors of production
such as wages and rent and various government regulations such as the increased taxes such as
corporate tax and VAT among others. The increased production costs reduce the firms’
profitability at their production level. They, therefore, minimize productivity to avoid further
decline in profitability and this reduces the economy’s aggregate supply. An occurrence of this
type of inflation makes the nation’s economic growth to decline. The real gross domestic product
decreases as unemployment increases since a decrease in aggregate supply decreases the quantity
produced and some workers are fired. An illustration is as follows.

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As illustrated in the above diagram, an economy’s aggregate supply decrease shifts the
aggregate supply curve to the left direction from AS to AS’. The nation’s economic productivity
declines as the real gross domestic product decrease from Y1 to Y2. The market prices in the
economy increase from P1 to P2 causing cost-push inflation.
b.
Causes of Demand-pull Inflation
Future inflation expectation causes demand-pull inflation (Godin & Lane, 2013). If
consumers expect inflation in future, they increase their consumption by purchasing more goods
and services to avoid future higher prices. This increases aggregate demand more than the
aggregate supply and hence causes demand-pull inflation.
The over-expansion of a nation’s monetary policy causes demand-pull inflation (Singla,
Ahuja & Sethi, 2017). This occurs as more money is availed in the economy by the government
printing more money through the central bank. Consumers hold more money and as a result,
increase their expenditure. This increases aggregate demand more than the aggregate supply and
hence causes demand-pull inflation.
Causes of Cost-push Inflation
Cost-push inflation occurs when firms raise their profit margin (Weale et al, 2015). In
order for firms to attain the raised profit margin, they increase their prices and also lower their
supply. This means that the aggregate supply is decreased and consumers suffer by paying the
higher prices tailored towards achieving the desired profit by firms. This causes cost-push
inflation as firms categorize it under production costs.

SEMISTER ASSIGNMENT 5
The occurrence of natural disasters causes cost-push inflation (Lima & Setterfield, 2010).
Supply is limited as the economy’s capital stock may be destroyed by the natural disaster such as
hurricanes and earthquakes. Also, natural resources may be depleted in the economy. This means
that firms have to produce and supply a few products in the economy as natural resources used in
production decrease. The economy’s aggregate supply decreases and firms raise their prices as
consumers compete for inadequate products and this causes cost-push inflation.
Question5
a.
Firms’ managers determine the profitability of the firm. When the managers of a firm
improve their skills in selling and marketing, they manage their teams well and hence raise the
firms’ sales. This is because they are able to convince more customers to purchase the firms’
products and hence increase the demand for the firm’s products. The aggregate demand in the
economy increases consequently. The below diagram is used for explanation.

SEMISTER ASSIGNMENT 6
An increase in the aggregate demand will shift the aggregate supply curve from AD0 to
AD1. The total output will increase from Q0 to Q1 improving the economic activity. The market
prices, on the other hand, will rise from P0 to P1 as illustrated in the above diagram.
b.
When the personal income tax in the economy is increased, consumers’ income level
decreases. They, therefore, reduce their consumption and hence reduce demand for firms’
products. The aggregate demand will decrease consequently. The aggregate demand curve will
shift to the left from AD0 to AD1. The economic activity declines as the total output will decrease
from Q0 to Q1. The prices in the economy will decrease from P0 to P1. An illustration has been
done in the below diagram.
c.

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When exports increase, it means that firms in the economy increase their productivity to
meet the rising demand for exports. This increases aggregate supply in the economy and the
aggregate supply curve will shift to the right from AS0 to AS1. The total output in the economy
will increase from Q0 to Q1 improving the nation’s economic activity. Prices in the economy, on
the other hand, will decrease from P0 to P1 as illustrated below.
d.
When the capital stock in the economy is destroyed, firms are left with few assets for
production. The aggregate supply will decrease as firms can only produce and supply a few
products using the few available assets. The aggregate supply curve will shift to the left from
AS0 to AS1. The total output in the economy will decrease from Q0 to Q1 causing a decline in the
nation’s economic activity. The prices in the economy, as a result, will rise from P0 to P1 as
shown in the below diagram.

SEMISTER ASSIGNMENT 8
Question6
a.
Advantages of Measuring Prices Using the Consumer Price Index (CPI)
By use of CPI, the inflation rate in an economy is obtained (Garcia, Restrepo & Roger,
2009). Price comparison for various years and their trends indicates by use of CPI indicates
inflation over the years considered. The government can, therefore, take the necessary action by
use of its fiscal and monetary policies to control the obtained inflation rate towards its target in
the economy.
CPI assists the government in its budgeting. CPI shows the income level of consumers in
the economy. The government based on the information obtained can budget the extent of
assisting its consumers by allocating proportionate funds towards projects made for assisting
citizens in raising their living standards.
Disadvantages of Measuring Prices Using the Consumer Price Index (CPI)

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CPI may give incorrect information about the inflation level in an economy (Alessandria,
2009). As the economy grows, some vital economy constituents may change and CPI rarely
considers their change. For instance, the technology level in the economy may advance and lead
to the production of high-quality products which will definitely be sold at higher prices. CPI will
definitely show an occurrence of inflation when it’s actually not true as the products higher
prices correspond to their quality.
The price level obtained by the CPI may be inaccurate. For instance, CPI cannot
accurately account for quality change for products used or even ignores it totally sometimes and
hence information obtained about general prices may be inaccurate. Products may improve their
quality and hence be sold at higher prices. CPI will show a price increase when it’s actually false
as the price increase matches the quality change.
b.
When inflation occurs, there are two probable outcomes on the affected parties. A win or
lose may occur based on the parties involved. The concept of the time value of money best
explains these outcomes. The concept bases its argument on the fact that, if inflation occurs
today, a given amount of money today may not be of value as it was in the previous period or
sometimes back before the inflation.
Some parties in an economy win when inflation occurs especially those who borrow
money and those who make fixed payments for their obtained loans. This is because they just
repay the fixed amount agreed which is not adjusted to match the current inflation level.
Therefore, they end up paying less in the sense that the amount repaid today after inflation
occurrence is of little value as compared to a similar amount before inflation.

SEMISTER ASSIGNMENT 10
On the other hand, some parties lose when inflation occurs especially those who lend
money and those who receive fixed payments such as fixed salaries. Those who lend money just
receive the agreed fixed repayment which is not adjusted in accordance with the current
inflation. The amount of money received during inflation is not as valuable as it was before
inflation. Those who receive fixed payments like pensioners, continue to receive the fixed
amount even after inflation. This lowers their standards of living in that the number of
commodities purchased after inflation using the money received decreases meaning that the
amount received after inflation is of less value as compared to the similar amount before
inflation.
Question7
a.
No. When securities belonging to the government are sold to banks, the available money
for lending in banks is reduced (Woodford, 2012). As a result, banks reduce their lending to
businesses and individuals and hence this reduces money supply growth in the economy.
b.
Yes. A decrease in interest rates reduces costs involved in money borrowing and
therefore the borrowed money is repaid with little interest. Businesses and individuals tend to
borrow more money for investment and expenditure in various activities after a fall in rates of
interest and hence this increases money supply growth in the economy.
c.

SEMISTER ASSIGNMENT 11
Yes. When the government borrows from the banking sector to increase its expenditure it
causes money supply growth in the economy. The government uses the borrowed money in
various projects which support its people. People are employed to carry out these projects and
also purchases from various sectors in the economy are done by the government. The payment
made to various workers and sectors in the economy increases money supply growth in the
economy.
d.
Yes. When the Central Bank buys government securities from banks, the amount of
money available for lending by banks is increased (Joyce et al, 2012). Banks increase their
lending to businesses and individuals and this increases money supply growth in the economy.
e.
No. the targeted inflation can be reduced by the Central Bank through increasing interest
rates. Businesses and individuals are discouraged from borrowing by the increased interest rates
and this reduces money supply growth in the economy.
Question8
a. “Imports of goods”.
b. “Exports of services”.
c. “Capital transfers sent overseas from the nation”.
d. “Investment in the nation from overseas”.
e. “Short-term financial outflows”.
f. “Other income inflows”.

SEMISTER ASSIGNMENT 12
g. “Drawing on reserves”.
h. “Short-term financial inflows”.
i. “Adding to reserves”.
j. “Exports of goods”.

SEMISTER ASSIGNMENT 13
References
Alessandria, G. (2009). Consumer search, price dispersion, and international relative price
fluctuations. International Economic Review, 50(3), 803-829.
Garcia, C., Restrepo, J., & Roger, M. S. (2009). Hybrid inflation targeting regimes (No. 9-234).
International Monetary Fund.
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.
Joyce, M., Miles, D., Scott, A., & Vayanos, D. (2012). Quantitative easing and unconventional
monetary policy–an introduction. The Economic Journal, 122(564), F271-F288.
Lima, G. T., & Setterfield, M. (2010). Pricing behaviour and the cost-push channel of monetary
policy. Review of Political Economy, 22(1), 19-40.
Singla, A., Ahuja, I. P. S., & Sethi, A. P. S. (2017). The effects of demand pull strategies on
sustainable development in manufacturing industries. International Journal of
Innovations in Engineering and Technology, 8(2), 27-34.
Smaghi, L. B. (2009). Conventional and unconventional monetary policy. Speech at the Center
for Monetary and Banking Studies, Geneva, 28.
Totonchi, J. (2011). Macroeconomic theories of inflation. In International Conference on
Economics and Finance Research (págs. 459-462). Singapore: IACSIT Press.
Weale, M., Blake, A., Christodoulakis, N., Meade, J. E., & Vines, D. (2015). Macroeconomic
policy: Inflation, wealth and the exchange rate. Routledge.

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Woodford, M. (2012). Inflation targeting and financial stability(No. w17967). National Bureau
of Economic Research.