cost push inflation

In an open economy such as the UK, there are many potential sources of inflationary pressure. Some come direct from the domestic economy, for example the decisions of the major utility companies on their prices for the year ahead, or the pricing strategies of the leading food retailers based on the strength of demand and competitive pressure in their markets.

But inflation can also come from external sources, for example a sudden rise in the cost of crude oil or other imported commodities, foodstuffs and beverages. Fluctuations in the exchange rate can also have a powerful effect on inflation in the short and medium term. For now, we focus on the two main causes of cost and price inflation in an economy.

Cost push inflation occurs when firms increase prices to maintain or protect profit margins after experiencing a rise in their costs of production. This can be shown by an inward shift of the short run aggregate supply curve which leads to a contraction in aggregate demand and a fall in real output, but an increase in the general price level.

The main causes of cost push inflation are:

Rising imported raw materials costs perhaps caused by inflation in other countries or by a fall in the value of the pound in the foreign exchange markets

Rising labour costs - rising labour costs are caused by wage increases, which are greater than productivity increases this, is especially important in industries, which are labour-intensive. If wages account for 25% of a firm's total costs then a 10% increase in the total wage bill will cause the firm's total costs to rise by 2.5%.

Firms may decide not to pass on this to their customers (they may be able to achieve some cost savings in other areas of the business) but in the long run - wage inflation does tend to move closely in line with general price inflation in the economy.

Higher indirect taxes imposed by the government - for example a rise in the specific duty on alcohol and cigarettes, an increase in fuel duties or a rise in the standard rate of Value Added Tax. These taxes are levied on producers who, depending on the price elasticity of demand and supply for their products can opt to pass on the burden of the tax onto consumers.

Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. This is shown in the diagram below. The fall in aggregate supply causes a contraction of real national output together with a rise in the general level of prices.

Cost inflation is more likely when unemployment is falling to low levels. In these circumstances there will be shortages of skilled labour. This means that businesses may have to offer higher pay to attract and retain their best workers when they are looking to expand their output