How is cost-pull inflation different from demand-pull inflation?

Highlights 

• Inflation is often considered a warning sign for an economy in distress, but it can also provide some respite in the instance of an economic slowdown.
• Two major types of inflation are demand-pull and cost-push inflation.
• Economic experts examine the source of inflation and dissect it to find better solutions to cope with it in the future.

Inflation is seldom received with welcoming arms as it is often taken as an indication of the economy going haywire. However, rising levels of inflation can often just be a warning signal, and in some specific instances, inflation can even act as an impetus to economic growth.            

Thus, finding out the root cause of prevailing inflation becomes especially significant to put the correct context behind it.

Additionally, inflation is a subject of interest not just for economic experts but also for the entire population as it impacts the purchasing power of money. Rising inflation erodes the value of money, rendering the existing money less valuable than before. Hence, economists diligently study the intricacies of economic inflation and dissect it to find stable methods to tackle it in the future.

ALSO READ: What is inflation?

Inflation primarily stems from four major forces in an economy:

• Demand-pull inflation
• Cost-push inflation
• Increase in money supply
• Decrease in demand for money

Among these, cost-push and demand-pull reflect the factors leading to inflation at the producer’s and the consumer’s end, respectively. Thus, both forms of inflation are especially significant in the field of economics.

Let us understand how demand-pull inflation is different from cost-push inflation:

Underlying differences

In fundamental terms, cost-push inflation refers to the scenario where rising input prices prompt firms to cut down on their production, causing a lack of supply. Since demand remains the same, a drop in supply creates a situation of excess demand prevailing in the economy where prices are bound to rise.

On the contrary, demand-pull inflation is a scenario that stems from the demand side factors. Here, economic growth causes demand to rise, ultimately encouraging consumers to spend more on goods and services. Thus, rising demand overshoots the existing supply, leading to a buildup of inflated prices caused by excess demand in the economy.

Therefore, both these forms of inflation depict a completely different story about the economy. While cost-push inflation signals a downturn in profits for firms, demand-pull inflation can sometimes be a sign of a developing economy undergoing rapid growth.

To summarise, when the aggregate supply of goods and services declines due to rising input prices for firms, it leads to cost-push inflation. Whereas demand-pull inflation sets in when aggregate demand in an economy increases due to external growth factors.

Interesting read: Why is deflation more dangerous than inflation?

Structural differences

Now that the primary differences between both are understood, it is time to discuss how these differences take shape from both the consumer’s and firm’s perspectives.

Firms are affected by the prices of the four factors of production, namely, land, labour, capital, and entrepreneurship. Any fluctuations in either of these factors can consequently affect the firm’s profitability. Additionally, any taxes or policies that harm the firm’s revenue stream can also push up the costs for firms. And these increased costs are passed onto the customers in the form of more expensive goods and services to maintain firms’ profit margins.

If the goods and services are highly elastic, meaning they can be easily substituted for another good, or are not a necessary part of consumer lifestyle, rising prices would have little to no effect on the demand for the good. Therefore, cost-push inflation usually takes place in the case of inelastic goods.

On the other hand, demand-pull inflation can arise from a range of economic stimulants. These include increased government spending, reduced taxes, and increased overseas demand. For example, consider a government that provides economic stimulus in the form of reduced taxes or as a financial benefit for those unemployed. Here, the additional disposable income received by the consumers would be used for supplementary purchases.

RELATED READ: What is monetary policy and why is it so important?

Thus, a scenario where demand pulls the strings on inflation does not appear to be as dangerous. The underlying factors pushing up prices in case of demand-pull inflation are quite prevalent in economies, unlike cost-push inflation. However, that does not necessarily imply that demand-pull inflation is desirable. Any harm caused to the buying capacity of the consumers, especially when it is prolonged, is detrimental to the overall economic growth.

A recent example of demand-pull inflation is the sharp recovery in aggregate demand from the virus crisis over the one year. As businesses remained closed for an extended period and economic activity was at a standstill, consumers were initially left with only a little cash to spare for expenses. Thus, when the economy reopened and revived, consumer demand improved substantially, triggering inflationary concerns in some advanced economies. It is worth noting that any kind of inflation can cause concern and should be perceived carefully by experts.

DO NOT MISS: Do you have a habit of splurging money? Try these money saving formula