Question

Identify the two descriptions below as being the result of either cost-push inflation or demand-pull inflation. a. Real GDP is below the full-employment level and prices have risen recently. b. Real GDP is above the full-employment level and prices have risen recently.

Short answer

Description a is cost-push inflation; Description b is demand-pull inflation.

Step-by-step solution

Understand Cost-Push Inflation

Cost-push inflation happens when the overall price level rises due to increases in the cost of wages and raw materials. This can occur even if the economy is below full employment because producers pass on the higher costs to consumers.

Understand Demand-Pull Inflation

Demand-pull inflation occurs when the demand for goods and services exceeds supply, often when the economy is operating above its productive capacity or full-employment level, causing prices to rise as consumers compete for limited goods.

Analyze Description a

The statement mentions that real GDP is below the full-employment level with rising prices. This scenario is typical of cost-push inflation, where price levels increase due to rising production costs, despite the economy operating below its full capacity.

Analyze Description b

Description b indicates that real GDP is above the full-employment level and prices have recently risen. This situation fits the definition of demand-pull inflation, where increased demand surpasses supply capabilities, pushing prices upward when the economy is over its full-employment threshold.

Key concepts

Cost-push inflation

Cost-push inflation is a situation where the prices of goods and services increase, not because there is more demand, but because the costs to produce those goods and services go up. This can happen even if there are fewer people working or less economic activity than usual. Typically, this type of inflation results from the increased costs of production inputs such as wages and raw materials.

Let's break it down:

• Higher Wages: If workers demand higher wages, businesses may have to increase the price of their products to cover these extra costs.
• Raw Materials: An increase in the price of raw materials (e.g., oil, steel) also forces companies to hike prices to maintain profit levels.

These higher costs are often passed down to consumers as higher prices, which means overall inflation, even if the economy is not at full employment.

For example, if the price of oil goes up significantly, this affects transportation costs, making it more expensive to deliver goods to stores. Businesses then need to charge more to cover these costs, leading to higher prices for consumers.

Demand-pull inflation

Demand-pull inflation happens when there is a surge in demand for goods and services. This surge can be so strong that it outpaces the economy's ability to produce these goods and services. When this happens, prices naturally go up since everyone is competing to buy the available products.

Key factors causing demand-pull inflation include:

• Increased Consumer Spending: If more people are spending more money, possibly due to economic growth or increased income, the demand rises.
• Government Spending: When the government injects money into the economy through projects or subsidies, it can boost demand.
• Investment Spending: Companies investing in expansion can increase demand for materials and labor.

In a nutshell, when an economy is running hot and real GDP exceeds full-employment levels, demand-pull inflation is likely to occur. Essentially, it's too much money chasing too few goods.

Real GDP and full employment

Real GDP refers to the total economic output of a country, adjusted for inflation, providing a more accurate reflection of an economy's size and how it's performing. When we talk about full employment, we mean the highest amount of economic output an economy can sustain over the long-term without creating inflation.

In simpler terms, full employment doesn't mean zero unemployment, but rather a situation where any unemployment is at its natural level (e.g., people changing jobs or entering the workforce).

Real GDP and full employment are crucial for understanding the broader economic conditions:

• Above Full Employment: If real GDP is above the full-employment level, the economy might be overheating, leading to demand-pull inflation as described above.
• Below Full Employment: Conversely, if real GDP is below full employment, it may indicate unused capacity and potentially more prevalent cost-push inflation due to insufficient demand.

Balancing real GDP and maintaining full employment is a key economic goal, as it helps ensure stable prices and sustained economic growth.