Page 180 - DECO201_MACRO_ECONOMICS_ENGLISH

Unit 10: Theories of Inflation

10.3.3 Demand Pull vs. Cost Push Inflation Notes

The issue whether inflation is a ‘demand pull’ or ‘cost push’ is being intensely debated since the
late 1950s. If demand pull is the correct diagnosis of inflation, the “government” must bear the
balance for excessive spending and too little taxing while the monetary authorities (the central
bank) are to be blamed for pursuing a “cheap money policy”. If, on the contrary, cost push is the
real cause of inflation “trade unions” are to be blamed for excessive wage-claim, industry for
acceding to them, and business firms for “marking-up” profits under conditions of monopoly or
oligopoly.

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Caution Some economists argue that there cannot be such a thing as a cost push inflation
because any increase in costs without an increase in purchasing power and demand would
lead to unemployment and depression, and not to inflation. It is impossible to think of a
process of continuous price rise, it is argued, if there is no increase in demand or the
quantity of money and bank credit. On the contrary, many economists subscribe to the
view that demand pull is no cause of inflation, only a cost push can produce it. But it seems
unrealistic to view the demand pull and cost push in exclusion of each other. Prices increase
as a consequence of complex interactions among wages, costs and excess demand in goods
markets, labour market and money market.

Empirical studies have also pointed to difficulties in the proper identification of demand and
cost inflation. Prof. Harry G Johnson considers the entire controversy between demand pull and
cost push as spurious for three reasons.
First, the advocates of the two theories fail to investigate the monetary assumption upon which
the two theories are based. A sustained inflation cannot be generated either by cost push or by
demand pull unless the behaviour of the monetary authority is taken into account under the
varying circumstances. Johnson remarks, “The two theories are, therefore, not independent and
self-contained theories of inflation, but rather theories concurring the mechanism of inflation in
a monetary environment that permits it.” Johnson has stressed that the real issue between the
two is not what causes inflation but whether inflation can be checked through the mechanism of
cost and price determination or by checking the aggregate demand through monetary and fiscal
restraints.
Second, Johnson says there is difference between the two theories about the definition of full
employment. If full employment is defined as a situation when the demand for goods is just
sufficient so that the price level neither rises nor falls, then inflation must be associated with
excess demand by reference to the level of unemployment at which the unfilled vacancies are
just equal to the number of job seekers or by reference to some percentage of unemployment
regarded as normal – inflation will do-exist with some unemployment. This type of inflation
can be explained only by reference to the forces that push up prices in spite of the absence of
excess demand. So the whole controversy boils down to the policy issue whether the present
level of unemployment is to be regarded as too great or too small.
Third, Johnson points out that it is almost impossible to devise a test capable of determining
whether a particular inflation is of cost push or demand pull variety. Most of the available tests
are extremely superficial in nature.

The debate between the two theories goes on unresolved. The crux of the entire matter is that
price movements are consequences of complex interactions of cost and demand adjustments
which are extremely difficult to identify and disentangle.

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