Inflation: Cost Push Inflation

Supply Shock Inflation / Cost Push Inflation

Inflation is also caused by increase in the cost of production. As a result of increase in the cost of production the aggregate supply schedule shifts downwards to the left, indicating that a lesser quantity is supplied at the existing prices. Aggregates demand schedule remaining unchanged, any leftward shift in the aggregate supply schedule will push
the prices upwards as could be seen in figure.
Cost Push Inflation
In the figure, DD is the aggregate demand schedule which remains unchanged; S1S1 is the original aggregate supply schedule which intersects DD at point K. At the full employment equilibrium point K, the level of full employment output is OY0 and the price level is OP1. With increase in the costs (may be due to rise in wage rates, higher prices or inputs, etc.), the aggregate supply schedule shifts to S2S2 intersecting the aggregate demand schedule DD at point K1. At new equilibrium point K1, the level of real output OY1 is less than the full employment output, therefore, the price level rises to OP2. A further shift in the aggregate supply schedule to S3S3 pushes the price level of OP3.

Causes of Cost Push Inflation

Cost-push inflation is generally caused by three factors.
  1. Increase in money wages: In the modern business world trade unions have become very well-organized and have been also to secure higher wages for their members. Whenever the products are compelled to accept the demand for higher wages by the trade unions, they try to shift the burden of increasing costs on to the consumers by charging higher prices for the final goods and services. This leads to ‘wage-price-spiral’. Increase in the wage rates leads to rise in prices, the real wages of the workers decline. To neutralize this fall, still higher wages are demanded and granted, and thus inflationary spiral continues.
  2. Higher profit margins: As discussed earlier aspiration for higher profit margin sets in motion ‘profit-push inflation’. This situation is typical to a sellers’ market in which demand exceeds the supply. Pressure on demand leads to increase in prices. Taking advantages of this situation, the producers set higher profit margins, which again would push the prices upwards.
  3. Rise in the prices of basic inputs: Scarcity of strategic and basic raw materials results in an increase in their prices, and in turn, the prices of final goods and services are increased. A fall in the supply of cement, iron and steel, sugarcane, cotton, etc., would raise their costs, and finally, the prices of the finished goods will also go up. The cost-push inflation may also be caused by the scarce supply of imported raw materials and intermediate goods.
  4. Administered higher prices of inputs: The prices of inputs do not always increase due to their scarcity but may increase due to some administrative action on the part of the government. Higher administered prices of basic inputs would affect the prices of final goods and services of the concerned business units. Thus, rises in administered prices sets in motion, the cost push inflationary forces in the economy.
  5. High rate of taxes: Taxes imposed on goods and services (i.e., indirect taxes) also generate inflationary pressure in the economy. As a result of increase in indirect taxes, the prices of raw material in international market. It is also known as supply shock inflation.
  6. International reasons: Another case of supply inflation on cost-push inflation is prices of the raw material in international market. It is also known as supply shock inflation.

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