DEMAND-PULL INFLATION & COST-PUSH INFLATION

1. Using appropriate diagrams, explain the difference between the demand-pull inflation and cost-push
inflation

A. Demand-pull inflation

Demand-pull inflation happens when there is an increase in the aggregate demand in the
economy and output of production cannot contain it. This can be triggered by many factors. It may first
be triggered by increase in the money supply than the increase in the level of production. This is an
example of a monetary expansion. Since there is a lot of money, the consumers demand more, pushing
the aggregate demand to the right. Other factors may be decreases in taxes, increase in investments,
decrease in savings. These actions constitute increase in income for consumers to spend or “disposable
income”. Increase in exports and decrease in imports also causes demand-pull inflation as the income
increases which pushes the population to demand more goods and services.

B. Cost-push inflation
 Cost-push inflation happens when decreases and causes the increase in price. This is caused by
shortage of a key resource that affects the level of production such as oil, steel or some other resource.
Other inputs may be factored in such as labor or capital. When there is a shortage of these inputs, the
tendency is production output will decrease which causes the supply to shift to the left. Another reason
of this, is the existence of monopoly in the economy. Monopolies can manipulate prices to further
maximize profit. The aggregate supply becomes sensitive with the number of outputs produced. This is
also called the profit-push inflation.

2. Why is cost-push inflation potentially more serious than demand-pull inflation?

Cost-push inflation is more serious than demand-pull inflation because cost-push inflation is
more difficult to be fixed. The problem here is related to the price of production inputs which causes
prices of goods and services to elevate as well. This is depicted by a fall of the aggregate supply, shifting
it to the left. Now, this cannot be easily fixed by monetary policy for that only affects the aggregate
demand. In order to fix this, the government is expected to intervene in terms of establishing an
administrative control on price rise and income policy in order to also control the inflation. If not, then
the increase in prices will move upward spiral and will causes further price hikes which may lead to
hyperinflation.

3. Using diagrams show the effects on the price level of the following events and explain whether it is
cost-push or demand-pull inflation.

A. Real GDP in foreign countries that trade with your country increase

It will be demand-pull inflation. As the Real GDP in the other country that we trade with
increases, prices in that country also increases following the economic expansion. Now, since their
prices are higher, the home country is less likely to import products from them. As a result, our imports
decrease and causes our Real GDP to increase as well which then shifts the aggregate demand to the
right, since income is higher. Thus, the demand-pull inflation.
B. Businesses are optimistic in the future

When businesses are optimistic, demand-pull inflation happens. When businesses are
optimistic, investments also increase. This will increase aggregate demand which in turn elevates the
price levels together with the expansion. Therefore, it is demand-pull inflation.

C. An increase in housing prices

If housing prices increases, the wealth of the house owners increases as well. Since the asset’s
worth increases, the owners will have more confidence to spend, borrow, invest and take risks. This is
also known as the “wealth effect”. The increase in expenditure and investments will trigger the increase
in aggregate demand which then elevates price levels. Thus, the demand-pull inflation.
D. A sudden increase in the price of oil

This will cause a cost-push inflation. Oil is considered as a salient factor of production in most
industries. Sudden increase in oil prices leads to the increase in the cost of production. As the
production cost increases, the number of goods produced will decrease. This will decrease the amount
of aggregate supply in the economy and elevate prices. Thus, the cost-push inflation.

4. What component of AD does each event affect?

A. Real GDP in foreign countries that trade with your country increase

This event would affect the trade, specifically import part. Since, the home country would less
likely buy from other country since the prices there is high. Thus, aggregate demand would increase and
elevate price levels due to the decrease in imports.

B. Businesses are optimistic in the future

This event would affect investments. As the business climate becomes better, people tend to
invest more expecting higher returns. Thus, the increase in the aggregate demand.

C. An increase in housing prices

This event would affect mainly consumption. Since wealth effect factors in, people tend to
spend more since they are more confident due to the safety net given by the increase in value of the
asset. This also true with their confidence in taking loans and investing.

D. A sudden increase in the price of oil

This would affect consumption. Since the price levels are higher, the aggregate demand in
consuming oil decreases.