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Economics: Demand-Pull and Cost-Push Inflation


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  • Type: Video Tutorial
  • Length: 10:00
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 107 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Fluctuations: Unemployment & Inflation (18 lessons, $22.77)
Economics: Inflation (6 lessons, $9.90)

In this video lesson on economics, we'll look at causes of inflation in the short-run, including both Demand-Pull and Cost-Push Inflation. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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We've been talking about inflation as if it just falls from the sky, as if it appears by magic. And I hope you've been wondering about the causes of inflation. What is it that happens in the economy that lights the spark that becomes a general, pervasive rate of increase in the price level?
In this discussion, we're going to look at two stories about where inflation comes from. In one story, we're going to focus on the demand side, and we find that when inflation is pulled along by increases in demand, it's associated usually with a booming economy - that is, an increase in the real gross domestic product. In the second story, we'll see inflation that begins by activity on the supply side, the so-called cost-push inflation. And in these cases, what we'll find is that rising prices are correlated with a shrinking economy; that is, prices are going up while the real gross domestic product is probably actually going down.
So we'll begin with explanation number one - demand-pull inflation. Demand-pull inflation begins when consumers, businesses, the government, and/or foreigners suddenly decide for whatever reason that they want to do more shopping. Maybe it's because the stock market is booming robustly, and people are anticipating more wealth down the road. Therefore, they decide, "Why wait? Why not go spend some of this newfound wealth now?" So they show up at the store, and they want more of the goods and services that money will buy, and people want to enjoy their anticipation of prosperity by shopping today for goods and services.
So with this increase in shopping, what we find happening is that factories have to increase their output to keep up with all the stuff that consumers, businesses, and foreigners want to buy. So the increase in demand leads to an increase in production. But to increase the production, especially in the short-run, you've got to go get lots more stuff - you've got to get more workers, you have to get more raw materials, etc. And in order to get more workers, you're going to have to draw down the labor pool.
Now, if the economy was already doing well before this increase in demand, then we might have been very close to the NAIRU - the non-accelerating inflation rate of unemployment - which means that if you want to increase output further to meet the extra demand for goods and services, you've got to coax people to work who weren't working before, or you've got to hire workers away from less lucrative opportunities. Anytime you hire more labor, you're going to have to pay more for that labor. That is, the paychecks that you have to give workers to get them to come and work for you.
However, if you're in an economy that's really booming along, you may discover that not only do you have to pay your workers, not only do you have to increase the number of paychecks that you're paying out to produce these goods and services, but you may have to increase the paychecks. That is, you may have to give workers raises and bonuses and other things, just to get them out of other employment, into your factories, to produce the goods and services that people want to buy.
So what we see then is that demand-pull leads to increased hiring. The increased hiring draws down the labor pool, and forces employers to pay higher wages; it increases their cost of production. Now when the costs of production increase, then businesses have to pass these higher costs of production on in the form of higher prices for goods and services. These goods and service rising prices may cause the employees then to say that they need adjustments in their salary to keep them up with the cost of living. These cost-of-living adjustments then allow them to continue to buy the goods and services that they were enjoying buying.
So here we now have a wage-price spiral working. That is, once demand-pull has begun to increase labor costs for the firm, because they had to pull down the ranks of the unemployed and begin to hire people away from other productive employment, once labor costs have started to go up, the companies, in order to remain profitable, have to pass these higher labor costs on to the customers in the form of higher prices. Once the prices of goods and services are rising, then the workers demand cost-of-living adjustments to keep them up to date with inflation, so that their purchasing power of their salaries won't shrink. As we add on more cost-of-living increases for workers, the company has to continue to raise prices, and before too long, we've got an inflationary spiral. Higher prices lead to higher wages, which are passed on in the form of higher prices, which cause workers to demand higher wages.
Now the thing about demand-pull inflation, and the wage-price spiral that's associated with it is that typically, this kind of inflation is associated with a boom in the economy. I mean, look, people are buying stuff, and, therefore, factories are producing stuff, and people have jobs, and the economy is expanding. So demand-pull inflation is typically inflation in an expansionary economy.
Now the alternative to demand-pull inflation is what we call cost-push inflation. Cost-push inflation doesn't begin with people doing more shopping. In fact, what happens is something quite exogenous. That is, we're clipping along here with workers getting their salaries, buying stuff, and maybe the economy starts in a position of price stability. Then what happens is what we call a supply shock. Say the price of oil suddenly shoots up because of conflict in the Middle East, or the oil producing and exporting countries forming a cartel and raising the price they charge to export oil to the United States and other oil-importing countries.
If we have a supply shock, what happens then is the cost of doing business increases. When the cost of doing business increases, businesses say, "Well, look, we already have to pay our workers. Now we've got to pay this extra high price for oil. What are we going to do?" And they find then that it's not profitable to continue to produce as much stuff as they were producing now that their costs of production have gone up. Therefore, what happens is the companies may actually lay off some of their workers, and produce fewer goods and services so that the economy contracts. That is, with less production, the workers who don't get paychecks do less shopping, and factories produce fewer goods and services.
The prices may still be rising in this economy, because the factories have to pass on to consumers the oil price increase that they have found themselves subject to. That is, higher oil prices mean higher prices at the checkout counter. But because companies are now going to be doing less overall production, because the higher oil prices have made some businesses unprofitable, production is cut back, the companies don't produce as much as before. They don't employ as much labor as before, and therefore workers have less to spend. This is what we call stagflation - higher prices that are created by a cost-push, but we may also get a contraction in the economy as businesses find that they can't profitably produce the same output that they were producing before. We had this stagflation in 1974; we had it again in 1980.
Now, demand-pull and cost-push inflation are two different stories about where inflation comes from. One begins with people deciding, "We're going shopping," the other begins with companies deciding they have to raise prices to account for higher input prices, like higher oil prices. Both of them wind up with higher prices at the checkout stand, but demand-pull winds up with more shopping and more output overall, pushing up against the speed limit of the economy. Cost-push winds up with less output, because the higher prices are reflecting the hardship that companies find themselves under, because they're having trouble making a profit because of the oil prices.
One more thing to say about inflation is that the wage-price spiral that sometimes develops in an inflationary environment is locked in by certain contractual instruments like cost-of-living adjustments that are in contracts that are negotiated by labor unions, and social security payments, and things like that. When there are cost-of-living adjustments, then people's wages go up automatically with the consumer price index, or some other agreed-upon measure of the rate of inflation. This makes the wage-price spiral harder to break. In an inflationary environment, whenever people's wages are not going up at the same rate as prices, then people find themselves inclined to spend more money now, because they're afraid that if they don't spend their money now, if they were to put it in the bank, that it won't buy as much when they take it out later. This concern about the real return on savings sometimes makes an inflationary environment worse. That is, when prices are going up, people say to themselves, "I'd better spend my money now rather than save it." But when everyone spends now, that exacerbates the demand-pull; by spending, people are pushing up prices further.
Two stories about inflation, with two different implications for output. But both of them account for the observation that prices may rise across the economy under certain circumstances.
Economic Fluctuations: Unemployment and Inflation
Short-Run Causes: Demand-Pull and Cost-Push Page [2 of 2]

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