Cost-Push Inflation
Starting from point E1, where economy is in a full employment
equilibrium, a supply side shock shifts the short run aggregate supply
inwards from SAS1, to SAS0. As a result, the equilibrium moves from
E1 to E2, increasing the rate of inflation to pi(2). The difference between
pi(2) and pi(1) is cost push inflation. A supply side shock like this
occurs when the economy suddenly experiences a rise in the cost of
production. This can happen due to a rise in oil prices because oil is a
basic factor for production and a rise in its price can increase power
generating costs, heating and lighting costs, transportation costs,
distributions costs, etc. In other words, we can say that a rise in oil prices
will result in a domino effect. Another source of supply side shocks
could be strong and powerful trade unions, which can sometimes bargain
for higher nominal wages, over and above the marginal productivity of
labor, thus increasing labor cost per unit of output. It would be a
significant increase in the production costs of the economy, especially
those which are labor intensive, making them extremely sensitive to
changes in wage rate.
A very important distinction between demand pull inflation and cost
push inflation is that, under demand pull inflation, the excess of
aggregate demand pushes economy above the full employment level
which increases the rate of growth of output but reduces the rate of
unemployment. In other words, in demand pull inflation, the rate of
inflation and the rate of unemployment move in opposite directions. In
contrast, under cost push inflation, we can see in the diagram above, that
the supply side shock reduces output below full employment, thus
increasing the rate of unemployment when the rate of inflation rises. In
other words, under cost push inflation, the rate of inflation and the rate
of unemployment move in the same direction and this direct relationship
between inflation and unemployment is also known as ‘stagflation’.