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Cost-push inflation

Inflation which is created and sustained by increases in production costs, independently of the state of demand. A good example of such inflation would appear to be that which took place in all western industrial countries following the exceptional increases in oil prices of 1973 and 1978. The most common source of cost-push inflation is held to be the power of trade unions to gain wage increases in excess of productivity increases, leading to price rises, further wage claims, and so on, in an ‘inflationary spiral’. Critics of this theory argue that if trade unions succeeded in raising wages and prices at times when the leve! of aggregate demand has not risen by enough to justify this, there would be a teildency for unemployment to increase, with subsequent deflationary effects on the economy. Such a process could not continue indefinitely, and therefore cost-push certainly could not explain the persistent inflationary processes in virtually all West-European economies since the Second World War. Either the price increases must be ‘ratified’ by stimulation of aggregate monetary demand to prevent the unemployment, or the inflation in fact is due to excess demand in the first place. This. latter proposition essentially argues that advocates of the cost-push theory rnistake the mechanism of adjustment for a motive force of the process. Suppose that when firms experience increased demand for their products; they do not raise prices, hut instead attempt to increase output by increasing overtime, employing more workers, etc. This increased demand in the labour market then leads to increases in wage earnings and wage rates (these increases taking place in negotiations between unions and employers). As a result of these wage increases, firms are forced to raise prices. Clearly, however, the motive force for the price rises came from the demand increases: the wage negotiations are simply the mechanism by which excess demand is translated into wage and price increases. The argument that inflation is caused either by ratification of wage increases, or simply by excess demand in the first place, has important implications for the control of inflation. If the purely cost-push theory is accepted, then either the government must sit back and allow unemployment to develop or it can try to intervene in the bargaining process with political/ administrative measures to restrain unions in ‘their demands for inflationary wage claims. On the other hand, if the theories based on excess demand are accepted, then the only really effective way to control inflation is to use monetary and fiscal policies to restraiil the level of aggregate monetary demand.

Reference: The Penguin Dictionary of Economics, 3rd edt.