Cost Push Inflation

In my previous article, I discussed the various causes of demand pull inflation. There is another type of inflation we see in open economies, which is called the cost push inflation. While the demand pull inflation is the sort of inflation that causes the costs to rise owing to an increase in demand, it is the sort of inflation which is caused by rising costs on account of various factors.

What is Inflation?

Let me first address the rather basic question on what is inflation to begin with and what causes inflation. Inflation is a general and sustained increase in the prices of goods and services in the economy. With rising prices, it also affects the value of the currency, effectively reducing the purchasing power of one unit of it. Inflation, when restricted to 2-3%, is viewed as a positive pointer of economic growth, as it indicates that there is an increase in the demand and financial stability in an economy. Too much of it of course is undesirable and potentially debilitating.

Defining Inflation

Now there are two main types of inflation - demand pull and cost push inflation. Both these two inflationary tendencies work in tandem to determine the final rate of inflation in an economy. So while demand pull inflation concerns itself with the demand side of things, cost push inflation is the type of inflation which is necessarily related to rising costs for whatever reasons.

Let us take the most widely touted example. In the 1970s, the OPEC nations decided to create a supply shock, leading to a sudden spike in the prices of oil. Now, oil being an essential commodity in several industries, the increase in the price of oil had an impact on the prices of all the industries which used oil as a raw material, raising their cost of production. To break even, those industries had to increase their own prices subsequently. This led to an increase in the prices of goods all throughout the economy, which was primarily due to the 'pushed up' cost of oil.

Causes of Cost Push Inflation

The definition states that cost push inflation is a sustained increase in prices, primarily due to an increase in the cost of wages and raw materials. So clearly rising wages and rising cost of raw materials are two of the very potent factors which affect it. When these costs rise, the companies raise the prices of their finished product to protect their profit margins. But then, a lot of items which are end products for one company are raw materials for another company (like oil). Then with the price of the end product being driven higher, there is an increase in the price of the second product as well.

With increase in wages of employees, they get a higher purchasing power, which leads them to purchase more goods and drives up the demand and therefore, the prices. The other important factor is the fluctuation in exchange rate. If this fluctuation is not in favor of your home currency, this can drive up the cost of imports and therefore, production. Government imposed taxes too can raise the cost of goods and if the item is an important one, it will raise the prices of all the subsequent goods as well.

Like I said before, sustained inflation of about 2-3% every year is indicative of a healthy, demand-fueled economy. An inflation rate higher than that can become troublesome.