Inflation has often been described as the clueless tax,
because it eats away at our savings and at our paychecks.
For example, if the rate of inflation exceeds the rate of growth in our paycheck,
that means our real income or purchasing power is
actually declining even though our wages are going up.
This figure illustrates these two main types of inflation,
demand pull versus cost push within an aggregate supply, aggregate demand framework.
You could see in the left hand figure which illustrates demand pull inflation,
how an outward shift in the aggregate demand curve,
an AD to AD prime results in an increase in the level of
real gross domestic product from Q to Q prime as
well as an increase in the price level from P to P prime.
By contrast, you can see on the right side an example of cost push inflation.
In this case, the aggregate supply curve shifts inward due to a rise
in production costs that may come from any number of supply side shocks.
For example, a spike in energy prices due to conflict in
the Persian Gulf or a spike in food prices due to a worldwide drought.
You could see in this case,
that the negative supply side shock causes the price level
to increase from P to P double prime.
However, in addition to this inflation,
we get a recessionary shock as well as real GDP downshifts from Q to Q double prime.
This is the classic case of stagflation: Simultaneous inflation
and slow growth or recession.
Knowing the difference between
and being able to recognize demand pull versus cost push inflation,
can be very important from a business strategy perspective.
For example, suppose you run a manufacturing plant that
is heavily dependent on energy input to produce your products.
Suppose further, that your economic forecasting team is
projecting a significant rise in energy prices over the next several years.
How might you strategically adapt these potential cost push pressures?
Take a minute now, jot down some ideas before moving on.
Dr. Peter NavarroProfessor
