Unit 2: Cost Push Inflation - Revision Notes

Cost-push inflation occurs when firms respond to rising costs, by increasing prices to protect their profit margins. There are many reasons why costs might rise:

1. Component costs: e.g. an increase in the prices of raw materials and other components used in supplying goods and services. This might be because of a rise in commodity prices such as oil, copper and agricultural products used in food processing. A good recent example is the surge in the world price of wheat


2. Rising labour costs - caused by wage increases, which are greater than improvements in productivity. Wage costs often rise when unemployment is low because skilled workers become scarce and this can drive pay levels higher wages might increase when people expect higher inflation so they bid for higher pay in order to protect their real incomes.

3. Expectations of inflation are important in shaping what actually happens to inflation! When people see prices are rising for the everyday items they purchase they start to get concerned about the effects of inflation on their real standard of living. One of the dangers of a pick-up in inflation is what the Bank of England calls “second-round effects” i.e. an initial rise in prices triggers a burst of higher pay claims as workers look to protect their way of life.

4. Higher indirect taxes imposed by the government – for example a rise in the specific duty on alcohol and cigarettes, an increase in fuel duty or a rise in Value Added Tax. Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers.

5. A fall in the exchange rate – this can cause cost push inflation because it normally leads to an increase in the prices of imported products. For example during 2007-08 the pound fell heavily against the Euro leading to a jump in the prices of imported materials from Euro Zone countries.

Cost-push inflation such as that caused by a large and persistent rise in the world price of crude oil can be shown in a diagram by an inward shift of the short run aggregate supply curve. The fall in SRAS causes a contraction of national output together with a rise in the level of prices