Demand-pull inflation happens when aggregate demand (AD)
increases in an economy and intersects the short run aggregate supply curve
(SRAS) to the right of where SRAS and long run aggregate supply (LRAS)
cross. This causes some inflation to
occur in the short run, and even more in the long run as the economy adjusts
(and the labor market moves back to equilibrium). Demand-pull inflation can occur for an reason that causes AD to increase but the most common are expansionary fiscal and
monetary policy, and positive expectations about the future (increased
growth/income expectations).
Cost-push inflation happens when SRAS shifts to the left
(decreases) and intersects the AD curve to the left of where AD and LRAS
cross. This will cause inflation in the
short run, but prices will drop back down again in the long run as the labor
market adjusts back to equilibrium (with wages dropping). Note that some classes ignore the long run,
and only care about where AD and AS cross and in this case cost-push inflation is
a permanent shift in the AS curve causing some amount of inflation.
A common question considers whether inflation caused by an
increase in wages (such as increasing the minimum wage) is caused by
demand-pull inflation or cost-push inflation.
In fact, it is caused by both. An
increase in wages is an increase in the cost of inputs which shifts the AS
curve to the left (a decrease). An increase in wages also translates to an
increase in income which means consumers can spend more making GDP larger and
shifting AD to the right (an increase).
These two effects happening at the same time mean that the
price level must rise, but that the new equilibrium point is uncertain,
depending on whether AD’s increase or AS’s decrease was greater in
magnitude. There are many ways to
consider this,
- The increase in costs is equal to the increase in income to the shifts must be the same and equilibrium GDP will be the same only at a higher price level.
- Assume that some of the income is saved or paid in taxes so the AD shift will be smaller than the AS shift.
- Finally, you can assume that the multiplier effects from the increase in consumption spending (and investment from savings and government spending from taxes) is large so that the AD shift will be larger than the AS shift.
The third scenario probably the most likely, but we do not
know for sure unless we have some equations or data to base it on. So the real answer here is that inflation
caused by an increase in wages is a double whammy of both demand-pull and
cost-push inflation, we cannot blame it on one source.
