Essential definitions

Demand-pull inflation

Inflationary pressure arising when aggregate demand grows relative to available supply.

Cost-push inflation

Inflationary pressure arising from higher production costs or reduced aggregate supply.

Real income

Nominal income adjusted for the general price level.

Demand pulls prices up

Demand-pull inflation begins with stronger aggregate spending. Suppose households and firms buy more. AD shifts right; firms increase output and hiring while resources are available. As workers and machines become scarce, extra production costs more and prices rise more strongly.

Read the diagram with the price level vertically and real GDP horizontally. AD1 meets SRAS at E1. Shift AD to AD2 and find E2 on unchanged SRAS. Project each intersection to both axes. The effect on output versus prices depends on the initial spare capacity, so explain that position before judging the shift.

Costs push prices up

Cost-push inflation begins with higher unit costs, such as imported fuel becoming dearer. Firms can profitably supply less at each price level, so SRAS shifts left. Its new intersection with unchanged AD has higher prices and lower output. This is different from demand-pull pressure, where output initially rises.

A single shift shows a price-level comparison. Continuing inflation needs further cost or demand pressure, or adjustments in wages and expectations that keep raising costs. If workers seek compensation for expected inflation and firms pass higher wages into prices, an initial shock can spread. The strength of this process depends on bargaining and productivity.

Explain who gains and loses

Unexpected inflation reduces the purchasing power of fixed money incomes and savings. With a fixed nominal debt, borrowers may repay in money worth less, at lenders' expense. Variable-rate contracts or anticipated inflation can alter that result. To value an unchanged money income at a new price index, divide it by that index and multiply by 100.

Unpredictable prices make planning and comparison harder; repricing also costs firms time and money. Faster domestic inflation can weaken export competitiveness if exchange rates do not offset it. Demand restraint may curb inflation but cost jobs, especially after a supply shock. Evaluate cause, predictability, duration and distribution instead of treating every price increase alike.

Apply and evaluate

• Unanticipated inflation has stronger redistribution effects than inflation fully incorporated into contracts.
• The best policy response depends on whether inflation originates mainly in excess demand or supply disruption.

Real-world application