Cost-Push Inflation

19 November 2019 by Tejvan Pettinger

Definition: Cost-push inflation occurs when we experience rising prices due to
higher costs of production and higher costs of raw materials. Cost-push inflation
is determined by supply-side factors, such as higher wages and higher oil prices.
Cost-push inflation is different to demand-pull inflation which occurs when
aggregate demand grows faster than aggregate supply.
Cost-push inflation can lead to lower economic growth and often causes a fall in
living standards, though it often proves to be temporary.

Diagram Showing Cost-Push Inflation

Short-run aggregate supply curve shifts to the left, causing a higher price level
and lower real GDP.

Causes of Cost-Push Inflation

 1. Higher Price of Commodities. A rise in the price of oil would lead to
higher petrol prices and higher transport costs. All firms would see some
rise in costs. As the most important commodity, higher oil prices often lead
to cost-push inflation (e.g. 1970s, 2008, 2010-11)
2. Imported Inflation. A devaluation will increase the domestic price of
imports. Therefore, after a devaluation, we often get an increase in inflation
due to rising cost of imports.
3. Higher Wages. Wages are one of the main costs facing firms. Rising
wages will push up prices as firms have to pay higher costs (higher wages
may also cause rising demand)
4. Higher Taxes. Higher VAT and Excise duties will increase the prices of
goods. This price increase will be a temporary increase.
5. Profit-push inflation. If firms gain increased monopoly power, they are in
a position to push up prices to make more profit
6. Higher Food Prices. In western economies, food is a smaller % of overall
spending, but in developing countries, it plays a bigger role. (food inflation)
Cost-push inflation could be caused by a rise in oil prices or other raw materials.
Imported inflation could occur after a depreciation in the exchange rate which
increases the price of imported goods.
Cost-Push Inflation – Temporary or Permanent?
This shows two periods of cost-push inflation in the UK – 2008 and 2011. These
periods of cost-push inflation proved relatively temporary because the economy
was in recession.

Many cost-push factors like rising energy prices, higher taxes, and the effect of
devaluation may prove temporary. Therefore, Central Banks may tolerate a
higher inflation rate if it is caused by cost-push factors. For example, in 2011, CPI
inflation reached 5%, but the Bank of England kept base rates at 0.5%. This
showed the Bank of England felt underlying inflationary pressure were low.

Different measures of inflation indicate cost-push inflation

In 2011, CPI inflation reached 5%, however, if we exclude the effect of taxes
(CPI-CT) inflation was 3%. If we also excluded the effect of higher import prices
(from devaluation) inflation would have been even lower.
Other economists may fear that temporary cost push factors may influence
inflation expectations. If people see higher inflation, they may bargain for higher
wages and thus the temporary cost-push inflation becomes sustained.

In the 1970s, there is evidence that temporary cost-push inflation fed into
permanently higher inflation. This is partly because workers demanded higher
wages in response to growing inflation.

Inflation of the 1970s.

In the 1970s, inflation was caused by the rapid rise in oil prices, and also rising
nominal wages. Workers had greater bargaining power to demand higher wages.

Measures of Inflation
Some measures of inflation seek to avoid ‘temporary cost-push factors’ For
example, CPI-Y excludes the effect of taxes. ‘Core inflation’ seeks to measure
inflation by ignoring volatile factors such as commodities and energy.

Policies to Reduce Cost-Push Inflation

Policies to reduce cost-push inflation are essentially the same as policies to

reduce demand-pull inflation.

The government could pursue deflationary fiscal policy (higher taxes, lower
spending) or monetary authorities could increase interest rates. This would
increase the cost of borrowing and reduce consumer spending and investment.

The problem with using higher interest rates is that although it will reduce
inflation it could lead to a big fall in GDP.

For example, in early 2008, we had a high period of inflation (5%) due to rising oil
and food prices. Central banks kept interest rates high, but this pushed the
economy into recession. Arguably, interest rates should have been lower and
less importance attached to reducing cost-push inflation.
In 2010, we might see a period of cost-push inflation, but, the Central Bank may
need to adopt a certain flexibility in inflation targeting. There is no point in rigidly
sticking to an inflation target if the inflation is caused by temporary factors.

The long-term solution to cost-push inflation could be better supply-side policies

which help to increase productivity and shift the AS curve to the right. But, these
policies would take a long time to have an effect.