Macroeconomics

Table of Contents

1. Topic pack - Macroeconomics - introduction
2. 2.1 The level of overall economic activity (notes)
3. 2.1 The level of overall economic activity (questions)
4. Section 2.2 Aggregate demand and supply (notes)
5. Section 2.2 Aggregate demand and supply (simulations and activities)
6. 2.2 Aggregate Demand and Aggregate Supply (questions)
7. 2.3 Macroeconomic objectives (notes)
8. Low Unemployment
   1. Low Unemployment
   2. What the data says
   3. The meaning of unemployment
   4. Case study - regional variation
   5. Consequences of unemployment
   6. Case study - tougher for men
   7. Types and causes of unemployment
   8. Disequilibrium unemployment
   9. Equilibrium unemployment
   10. Policies to reduce unemployment
   11. Low and stable inflation
   12. Low and stable inflation (notes)
   13. The meaning and measurement of inflation
   14. A consumer price index
   15. Finding out more about consumer price index weights
   16. Problems with measuring inflation
   17. Inflation - videos
   18. Consequences of inflation
   19. Hyperinflation
   20. The consequences of deflation
   21. Types and causes of inflation: demand-pull inflation
   22. Types and causes of inflation: cost-push inflation
   23. Case Study - car prices in Trinidad
   24. Possible relationships between unemployment and inflation
   25. PlotIT - Phillips curve
   26. Phillips curve - long-run
   27. Natural rate of unemployment
   28. NAIRU
   29. Economic growth
   30. Economic growth (notes)
   31. Causes of economic growth
   32. Economic growth and the PPF (1)
   33. Economic growth and the PPF (2)
   34. Economic growth and the business cycle
   35. Economic growth and the aggregate supply curve
   36. Consequences of economic growth
   37. Equity in the distribution of income
   38. Equity in the distribution of income (notes)
   39. Indicators of income equity
   40. Poverty
   41. The poverty line: An Indicator of Relative poverty
   42. The causes of poverty
   43. The role of taxation in promoting equity
   44. The role of taxation in promoting equity (notes)
   45. Other methods of promoting equity
9. 2.3 Macroeconomic objectives (questions)
10. 2.4 Fiscal policy (notes)
11. 2.4 Fiscal policy (questions)
12. 2.5 Monetary policy (notes)
13. 2.5 Monetary Policy (questions)
14. Section 2.6 Supply-side policies (notes)
15. 2.6 Supply-side policies
    
16. P(questions)
17. Print View

Types and causes of inflation: cost-push inflation

Syllabus: 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 (shift to the left of SRAS).

Cost-push inflation

Cost-push inflation happens when costs increase independently of aggregate demand. It is important to look at why costs have increased, as quite often costs are increasing simply due to the economy booming. When costs increase for this reason it is generally just a symptom of demand-pull inflation and not cost-push inflation. For example, if wages are increasing because of a rapid expansion in demand, then they are simply reacting to market pressures. This is demand-pull inflation causing cost increases.

However, if wages rise because of greater trade union power pushing through larger wage claims - this is cost-push inflation. Cost-push inflation is shown on the diagram below. The aggregate supply curve shifts left, because of the cost increase, pushing prices up.

In any case you need to be aware of the wage/price spiral where wages increasing cause prices to rise which causes trade unions to ask for higher wages (if only to maintain real wages) which pushes up prices further and so on...

Figure 5 Cost-push inflation

Notice that this is the only recommended use of the Short Run diagram - cost push inflation. The reason is that changes in variables that affect the costs of production must affect the SRAS curve as LRAS is determined by the Quantity and Quality of Factors of Production.

So why might costs get pushed up, causing inflation? There are a number of possible sources of rising costs.

Wages

If trade unions gain more power, they may be able to push wages up independently of consumer demand. Firms then face higher costs and are forced to increase their prices to pay the higher claims and maintain their profitability.

Profits

If firms gain more power and are able to push up prices independently of demand to make more profit, then this is considered to be cost-push inflation. This is most likely when markets become more concentrated and move towards a monopoly or perhaps an oligopoly position.

Imported inflation

Economies operate within a global contxt and many firms import a significant proportion of their raw materials. If the cost of these increase for reasons beyond their control, then firms may increase prices to pay these higher raw material costs, although this will depend upon elasticities of demand. Highr raw material costs may happen for several reasons:

• Exchange rate changes - if there is a depreciation in the exchange rate, a country's exports will become cheaper abroad, but its imports will become more expensive; firms will be paying more for their overseas raw materials.
• Commodity price changes - if there are price increases on world commodity markets, firms will be faced with higher costs if they use these commodities as raw materials; particulalry important markets will include the oil market and metals markets.
• External shocks - this could as the result of natural reasons or because a particular group or country has gained more economic power. An example of the first cause was the 2011 earthquake and tsunami in Japan, which disrupted production of Japanese goods and services for a prolonged period. An example of the second cause was when OPEC forced up the price of oil four-fold in the early 1970s.

Exhaustion of natural resources

As resources run out, their price will inevitably rise. This will increase firms' costs and may push up prices until they find an alternative source of raw materials (if they can). This has happened with fish stocks. Over-fishing has put many types of fish and fish-based products under extreme pressure, forcing their price up. In many countries, equivalent problems have been caused by erosion of land as forests are cleared resulting in the land becoming unsuitable for agriculture.

Taxes

Changes in indirect taxes (taxes on expenditure) increase the cost of living and push up the prices of products in the shops.

Expectations

Another factor that can accelerate cost-push inflation is a poulation's expectation of inflation. This sounds odd, but when you consider that employees build their expectation of inflation into their wage claims, you can see that this in itself can be a cause of inflation. If employees expect inflation to be 5%, they may expect a wage rise equal to, or in excess of, this level. If employees manage to obtain that wage increase, then this may cause further cost-push inflation as firms are face higher production costs, which firms attempt to pass on to consumers by charging higher prices. The higher inflation may then raise people's expectations further causing a vicious cycle or inflation spiral. Expectations can be a bit like a self-fulfilling prophecy. Higher expectations can actually cause higher inflation.

Policies to reduce Cost-Push Inflation

Clearly, the most appropriate policy depends on the reason for the increases in costs.

After the OPEC Oil Price rise mentioned above (1970´s) there was a wage/price spiral as trade unions tried to maintain the living standards of their members by asking for higher nominal wage increases, which pushed up prices as employers tried to maintain their profit levels, which led to futher wage demands and so on...

The Labour Government (Interventionist) reasoned that the spiral must be broken so introduced income and price policies. They pegged increases in wages and prices to per cent levels below the inflation rate reasoning that this would reduce inflation. When this proved problematic they tried fixed sum increase (eg GBP10 per week increase maximum).

These policies did work for a short time but interfences in the workings of the markets destroyed the price mechanism´s ability to send appropriate signals to markets. Relative wages for example were distorted remember that per cents of low incomes are not the same as per cents of higher incomes and fixed sums rewarded low income workers proportionately more than higher income workers.

After a short time of willing cooperation, trade unions put increasing pressure on government to remove the restrictions and this brought havoc in terms of strikes and other union anti-employer activities (work to rule was particularly amusing as, if all workers in a certain sector - eg rail workers- all worked strictly according to the rule book the sector ground to a painful halt). The explosion of wage increased wage demands after the removal of prices and Incomes policies was often referred to as the - cork in the bottle effect. Prices and incomes policies have not been seen since.

Most governments today focus interest rate policies on all kinds of inflation. They are easier to administer and have powerful effects on AD through consumption (C) and investment (I). Increasing the rate of interest reduces the willingness of consumers and business to buy on credit and borrow money (See Section 2.5 on Monetary Policy).

Inflation Essay questions

May 2014
3. (a) Using two AD/AS diagrams, explain cost-push and demand-pull inflation. [10 marks]

    (b) “The rate of inflation can be most effectively reduced through the use of monetary policy.” To what extent do             you agree with this statement? [15 marks]

November 2009
2. (a) Explain how the rate of inflation might be measured and the factors which might make accurate measurement difficult. [10 marks]

(b) Evaluate the extent to which an individual government can influence the rate of inflation in its economy. [15 marks]

May 2009

2. (a) Explain the possible causes of a rise in the rate of inflation in an economy. [10 marks]

     (b) Evaluate the possible impact on economic performance that may result from a government decision to bring            inflation under control. [15 marks]

May 2009

2. (a) Explain the possible causes of a rise in the rate of inflation in an economy. [10 marks]

    (b) Evaluate the possible impact on economic performance that may result from a government decision to bring             inflation under control. [15 marks]