Difference between Demand-Pull and Cost-Push Inflation

This article will help you to learn about the difference between demand-pull and cost-push inflation.

Difference between Demand-Pull and Cost-Push Inflation

Demand-Pull Versus Cost-Push Inflation:

No single explanation will suffice when we deal with a phenomenon as complicated as inflation in the modern economy.

Some economists object that inflation is either demand-pull or cost-push and feel that the actual inflationary process contains some elements of both.

These theories should not be taken as alternatives in any absolute sense but as approaches that lay stress on one factor relatively more than the other. In practice, it is very difficult to establish by empirical tests whether inflation is demand-pull or cost-push.

Pure demand-pull or a pure cost-push inflation is rarely found. It is true that modern economic analysis no longer sees the problem of inflation as basically a matter of too much money in circulation, but this does not mean that money supply is not important. Barring unprecedented shifts in the velocity of circulation of money (V), all the theories of inflation predicate increases in the money supply. H. Johnson, therefore, remarks, “The two theories are not independent and self-contained theories of inflation, but rather theories concerning the mechanism of inflation in a monetary environment that permits it.”

Fritz Machlup in one of his recent papers has presented another view of cost-push and demand- pull inflation. According to Machlup, inflation may be defined as a rising price level, yet it needs considerable expansion and clarification before it can really be considered meaningful. He deals with the contention that the distinction between cost-push and demand-pull inflation is unworkable, irrelevant, or even meaningless. There is a group of outstanding economists who contend that there cannot be such a thing as a cost-push inflation because, without an increase in the purchasing power and demand, cost increases would lead to unemployment and depression, not to inflation.

Similarly, there are assumptions for which it would be appropriate to say that demand-pull is no cause of inflation—it takes cost-push to produce it. In other words, the contention must be granted that there are conditions under which ‘effective demand’ is not effective and won’t pull up prices, and when it takes a cost- push to produce price inflation.

But this position ignores an important distinction, namely, whether the cost-push is ‘equilibrating’ in the sense that it ‘absorbs’ a previously existing excess demand or whether it is ‘dis-equilibrating’ in the sense that it creates an excess supply (of labour and productive capacity) that will have to be prevented or removed by an increase in effective demand.

Fritz Machlup identifies the limitations of the conventional approach to inflation and develops a more adequate framework in terms of the concept of autonomous, induced, and supportive demand inflation and aggressive, defensive, and responsive cost inflation. On the basis of these concepts, he has developed model sequences of the inflationary process and applied them briefly to what may be the most perplexing problem in the study of inflation—identifying whether any concrete inflationary experience was ‘initiated’ by cost-push or demand-pull forces.

The Structural Hypothesis:

Apart from the controversy about the demand-pull and cost-push theories of inflation in the USA, Prof. Charles Schultze put forward an alternative theory of inflation called structural inflation hypothesis or sectoral demand shift inflation theory. This theory was used to explain the American inflation of the 1950s through 1960s, 1970s, and the 1980s. It shows that inflation may be the consequence of internal changes in the structure of demand, even though overall demand may not be excessive.

This theory of inflation is based on the fact that in many areas and sectors of the economy wages and prices are flexible upward in response to increases in demand, but not flexible downward when demand declines. In other words, this theory emphasizes the fact that inflationary pressure can be generated by internal changes in the composition of demand alone. In a dynamic economy such changes are an essential part of the economic process, consequent upon changes in the structure of consumer tastes and desires.

The expansion of demand for the output of particular industries or sectors will lead to wage and price increases in these areas or sectors because wages and prices have an upward sensitivity when demand is rising. But the contraction of demand in other sectors will not lead to any corresponding downward movement of prices. Thus, overall, the average level of price will surely rise. The structural inflation thesis makes prices inflation inherent in the process of resource allocation, if wages and price are flexible upward but not downward. The structural inflation differs from demand-pull and cost-push inflations in that it stresses changes in the composition of demand.

In this type of analysis the starting point for inflation is a change in the structure and composition of demand, which means a rise in demand for the products of particular industries—this is a common feature in a dynamic economy. As a result, wages and prices rise upward in response to shifts in demand of certain sectors but do not fall in those sectors where there is a relative decline in demand. Not only prices and wages fail to fall in the industries where demand declines, they may actually rise.

The increase in wages and prices in industries and sectors with rising demand will force the demand deficient industries and sectors to pay higher wages and prices for labour and materials to continue their production. Thus, wage price increases in particular areas gradually spread out and permeate the whole economy.

The most important implication of the structural explanation of inflation is that ordinary monetary and fiscal measures of general character are not capable of coping with this type of inflationary situation. They may control the aggregate demand but not the structure or composition of demand which calls for different selective measures. However, the position has been well summed up by James Tobin’—who says that the nature of current global inflation specially of USA is complex, difficult to diagnose and unique in modern history.

In general, we may distinguish three types of inflation:

(a) Excess demand inflation—“too much money chasing too few goods”

(b) The wage—price—wage spiral

(c) Shortages and price increases, in important ‘commodities’

To this may be added another variety of imported inflation: as a result of unprecedented hike in oil prices by the OPEC Cartal after 1973 affecting the domestic prices of developed and developing economies particularly. According to Tobin our current inflation is a combination of (b) and (c) above but monetarists ignore all types of distinctions and consider current inflation due to (a) above.