Question

Identify the two descriptions below as being the result of either cost-push inflation or demand-pull inflation. \(L O 38.2\) 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 shows cost-push inflation; description b shows demand-pull inflation.

Step-by-step solution

Understand Cost-Push Inflation

Cost-push inflation occurs when the overall price levels in an economy increase due to a rise in the cost of wages and raw materials. This type of inflation is generally associated with supply-side constraints, where higher production costs lead to a decrease in the aggregate supply of goods and services.

Understand Demand-Pull Inflation

Demand-pull inflation occurs when the demand for goods and services exceeds their supply within an economy. This kind of inflation is typically associated with an increase in aggregate demand, where the economy's output level (Real GDP) might exceed the full-employment level, leading to a general rise in prices.

Analyze Description a

In description a, "Real GDP is below the full-employment level and prices have risen recently," notice that the economy's output is below full capacity, indicating supply constraints rather than increased demand. The rising prices could be the result of cost increases, such as those from raw materials or wages, fitting the definition of cost-push inflation.

Analyze Description b

In description b, "Real GDP is above the full-employment level and prices have risen recently," the economy is operating above its full capacity. This scenario typically indicates that the demand for goods and services is exceeding supply, leading to higher prices, characteristic of demand-pull inflation.

Conclusion

Assign the correct inflation type to each description: description a corresponds to cost-push inflation, and description b corresponds to demand-pull inflation.

Key concepts

Cost-Push Inflation

Cost-push inflation is a situation where the prices of goods and services increase due to rising production costs, which are often linked to greater costs for labor or raw materials. Unlike demand-pull inflation, this inflation type is driven by supply-side factors. When production becomes more expensive, companies may need to raise their prices to maintain profit margins, leading to overall higher price levels.

Key factors that can trigger cost-push inflation include:

• An increase in wages beyond productivity growth, which raises unit labor costs.
• Rising prices of raw materials such as oil, metals, or agricultural products.
• Supply chain disruptions that limit the availability of components, causing costs to increase.

These increased production costs can reduce aggregate supply, which is the total amount of goods and services that businesses in an economy are willing to provide. When supply contracts, but demand remains the same or grows, prices tend to rise. This can lead to inflation, even if there is no actual increase in demand.

Demand-Pull Inflation

Demand-pull inflation happens when the overall demand for goods and services in an economy outpaces the supply available, causing prices to rise. This scenario typically occurs in periods of economic expansion when consumers and businesses are spending more money.

Several factors can contribute to demand-pull inflation:

• Economic booms that lead to increased consumer confidence and spending.
• Government fiscal policies that increase public spending or cut taxes, boosting disposable income.
• Monetary policies that reduce interest rates, encouraging borrowing and spending.

When demand exceeds supply, producers may struggle to keep up with orders without raising prices, which results in inflation. This situation is often associated with a strong economy where Real GDP surpasses the full-employment level, creating pressure on prices as resources, including labor, become scarce.

Real GDP

Real GDP, or Real Gross Domestic Product, is a measure of the economic output of a country, adjusted for inflation. It provides a more accurate depiction of an economy’s size and how well it’s performing by measuring the value of goods and services produced over a specific period, excluding the effects of price increases.

Understanding Real GDP helps compare economic output across different years or countries by considering only the change in volume and not price levels. Here's why it's important:

• It helps in assessing the true growth of an economy by focusing on actual productivity.
• It provides insights into economic health and can drive policy decisions by showing whether the economy is expanding or contracting.

Real GDP surpassing the full-employment level may indicate overheating, where demand-pull inflation could occur as the economy operates beyond its productive capacity, straining resources.

Full-Employment Level

The full-employment level in an economy refers to the highest level of employment that can be maintained without causing inflation to increase. Despite the name, full employment does not mean zero unemployment; rather, it includes the natural rate of unemployment, accounting for frictional and structural unemployment. Frictional unemployment happens when individuals are between jobs or entering the workforce. Structural unemployment occurs when workers' skills do not match job requirements. These are normal, healthy parts of an evolving economy.

The full-employment level is crucial because:

• It signifies an economy operating at its optimal capacity, utilizing most of its labor resources.
• It helps policymakers design strategies to maintain employment levels without spurring inflation.

Operating above the full-employment level can lead to increased inflation, such as demand-pull inflation, as the economy may struggle to meet excessive demand for goods and services.