Q66+-+Macro+Short+Answers

66. Use an aggregate demand/aggregate supply diagram to explain how cost-push inflation may occur and outline two ways in which it might be controlled.

Cost-push Inflation is a type of inflation that is caused by an increase in the costs of production in an economy, that is, a shift of the SRAS curve to the left.

As mentioned above, an increase in factor costs on a macro scale can cause prices to rise due to the increase in costs. Cost-push inflation is frequently associated with ‘one-off’ increases in price level, known as supply-side shocks. There are a number of possible reasons for Cost-push inflation; wages rising faster than productivity gains in the economy; a fall in the exchange rate driving up the price of imported raw materials and components; or an increase in taxation forms levied on production, say labor taxes. All of these will shift the SRAS curve left to SRAS2 as shown in the diagram above thereby increasing average price levels from P1 to P2 and decreasing real output from Y1 to Y2 (stagflation).

Some potential solutions that would reduce cost-push inflation include deflationary demand-side policies such as tight monetary policy, which would reduce the supply of money thereby increasing interest rates. This would then reduce consumption and investment and increase saving thereby reducing Aggregate Demand. This would bring down the price level whilst resulting in lower national output and lead to unemployment. Another, more appropriate solution for cost-push inflation would be the use of supply-side policies such as deregulation, reduced taxes, education and training, or improved infrastructure. All of these solutions would then shift the LRAS curve to the right thereby reducing the average price level, which would counter act the cost-push inflation.