Demand-Pull

And
Cost-Push Inflation
Unit 10 - Lesson 5
Learning outcomes:
● Explain, using a diagram, that demand-pull inflation is caused by
changes in the determinants of AD, resulting in an increase in AD.
● Explain, using a diagram, that cost-push inflation is caused by an
increase in the costs of factors of production, resulting in a decrease in
SRAS.
● Discuss the possible consequences of deflation, including high levels of
cyclical unemployment and bankruptcies.
Types and Causes of Inflation
Two causes of inflation:

● Demand-pull inflation
○ Caused by increases in aggregate demand (AD)
■ increases in aggregate demand (AD) caused by changes in any of
the determinants of aggregate demand (AD)
● Cost-push inflation
○ Caused by increases in cost of production or supply-shocks.
■ Likely cause of increased cost of production is a depreciation of a
country’s currency.
● This makes imports more expensive
○ Oil, gas are inputs necessary to an economy.
Demand-pull Inflation
The graph to the right represents
Demand-pull Inflation - Monetarist view.

● The economy is operating at the “full

employment” level of output at Ypo
and average price level of APL
● Change in a determinant of aggregate
demand (AD) resulting in an increase
in aggregate demand (AD - AD1).
● After the increase in aggregate
demand, the economy is now in an
inflationary gap
Demand-pull Inflation
Graph explanation continued:
● Increase in aggregate demand (AD -
AD1) leads to an increase in output
produced from (Ypo - Yao)
○ Actual output produced is
greater than the potential
output.
● Increase in aggregate demand (AD -
AD1) leads to an increase in average
price levels (APL - APL1)
○ The increase in average price
levels is inflation caused by an
increase in aggregate demand.
Demand-pull Inflation
The graph to the right represents
Demand-pull Inflation - Keynesian view.

● The economy is operating at the “full

employment” level of output at Ypo
and average price level of APL
● Change in a determinant of
aggregate demand (AD) resulting in
an increase in aggregate demand
(AD - AD1).
● After the increase in aggregate
demand, the economy is now in an
inflationary gap
Demand-pull Inflation

Graph explanation continued:

● Increase in aggregate demand (AD -

AD1) leads to an increase in output
produced from (Ypo - Yao)
○ Actual output produced is greater
than the potential output.
● Increase in aggregate demand (AD -
AD1) leads to an increase in average
price levels (APL - APL1)
○ The increase in average price levels
is inflation caused by an increase
in aggregate demand.
Demand-pull Inflation
Demand-pull Inflation

● Excess aggregate demand in

relation to aggregate supply at the
“full employment” level of output.
○ Results in upward pressure on
average price levels resulting
in inflation.
○ Caused by an increase in
aggregate demand (AD)
Cost-push Inflation

Cost-push Inflation

● The economy is operating at the “full

employment” level of output at Ypo and
average price level of APL
● There is an increase in the cost of
production or supply-shock resulting in a
decrease in SRAS (SRAS - SRAS1)
○ The increase cost of production is
often the result in the depreciation
of a country’s currency.
Cost-push Inflation
Graph explanation continued:

● The decrease in SRAS results in the

economy entering a “Recessionary Gap”
● There is a decrease in Real GDP
produced from (Ypo - Yao)
○ Actual output is less than potential
output
● There is an increase in average price
levels (APL - APL1) -
○ The increase in average price levels
is inflation caused by an decrease
in SRAS.
Cost-push Inflation

Graph explanation continued:

● Unemployment increases
○ Unemployment is greater than the
natural rate of unemployment (NRU)
Cost-push Inflation
Cost-push inflation also known as
Stagflation is caused by a fall in
aggregate supply.

● Decrease in aggregate supply is a

result of increased wages or costs
of other inputs necessary to
produce the output of an economy.
○ This increase in cost of inputs
is often the result of a
depreciation of a currency.
Demand-pull and Cost-push Inflation Summary
Demand-pull and Cost-push Inflation impact on Macroeconomic Objectives
Though all inflation impacts an economy negatively, demand-pull inflation is
better than cost-push inflation.
Consequences and Causes of Deflation
Deflation

● Is the decrease in average price

levels

Why deflation rarely occurs?

● Where it is possible to see the price

of a particular goods and services
to decrease over a period of time it
is not likely that the average price
levels of the “fixed” basket of
goods and services will decrease.
Consequences and Causes of Deflation
There are several reasons why deflation - decreases in average price levels within
an economy are not likely to happen.

● Wages of workers normally do not decrease

○ Therefore it is difficult for firms to lower their prices as it would result in
lower profits.
● Large oligopolistic firms may fear price wars
○ If one firm lowers prices, then other firms may follow by lowering prices
even further in the hopes of gaining market share.
○ This would hurt all firms in the market as profits would decrease
○ Therefore firms avoid lowering prices
Consequences and Causes of Deflation

Reasons why continued:

● Firms want to avoid “menu
costs” that result from changes in
prices
○ This result in increased cost
to firms thus negatively
impacting profits.
Consequences of Deflation
Redistribution effects:

● Uncertainty
○ Creates uncertainty for firms as they are not able to accurately forecast
costs and revenues due to decreasing price levels.
● Menu Costs
○ Similar to inflation - Costs incurred by firms when they have to reprint
new menus, catalogues, advertisements and labels.
● Risk of bankruptcy and financial crisis
○ Deflation increases the Real Value of debt held by individuals and firms.
○ If the economy is in a recession, and incomes are decreasing while the
real value of debt increases the likely outcome is bankruptcy.
Consequences of Deflation
Redistribution effects continued:

● Risk of Deflationary Spiral

○ Deflationary spiral is a series of events that continually worsen deflation.
○ Deflation discourages spending by consumers as they hold off on
purchases in the hope of getting the good for cheaper.
○ Also, deflation discourages firms and consumers from borrowing as the
possibility of the Real Value of debt to increase as price levels decrease.
○ The result is consumer and business spending decrease leading to a
decrease in aggregate demand (AD).
○ If the economy is already in a recession, the recession will worsen with
decreasing aggregate demand, increased unemployment and further
decreases in prices.
Causes of Deflation
There are two types of deflation:

1. Decreasing Aggregate Demand (AD)

a. This is considered the “bad” type of deflation
i. Decrease in aggregate demand (AD) leads to a decrease in average
price levels, decrease in Real GDP output and increase in
unemployment
2. Increase in Short-run Aggregate Supply (SRAS)
a. This is considered the “good” type of deflation
i. Increase in short-run aggregate supply (SRAS) leads to a decrease in
average price levels, increase in Real GDP output and decrease in
unemployment.

All deflation is bad since it discourages consumption and investment spending.

Causes of Deflation
Deflation caused by a decrease in
aggregate demand:

● A decrease in aggregate demand (AD -

AD1) caused by a change in a
determinant of aggregate demand.
● Leads to a decrease in average price
levels (APL - APL1) - deflation
● Decrease in Real GDP output (Ypo -
Yao)
● Increase in unemployment
○ Cyclical unemployment is evident
in the economy
Causes of Deflation
Deflation caused by an increase in
short-run aggregate supply (SRAS):

● An increase in short-run aggregate supply

(SRAS - SRAS1) caused by a change in a
determinant of short-run aggregate supply
(SRAS).
● Leads to a decrease in average price
levels (APL - APL1) - deflation
● Increase in Real GDP output (Ypo - Yao)
● Decrease in unemployment
● Unemployment is less than the natural rate
of unemployment (NRU)