Model essay (a): demand-pull and cost-push inflation

What this lesson teaches

• I can explain the causes of weak growth, unemployment, inflation or deflation and a large trade imbalance.

  Syllabus 9570, 3.2.2(a). Macroeconomic Issues: Macroeconomic issues and their causes; Undesirable economic growth - persistently low or negative, unsustainable, non-inclusive due to factors such as changes in AD or AS, environmental degradation, inequitable income distribution; Unemployment - demand-deficient, structural, frictional due to factors such as lack of AD, technological changes, mismatch of skills, transition between jobs; Price instability - demand-pull inflation, cost-push inflation, deflation due to factors such as changes in AD, costs of production, productive capacity; Persistently large balance of trade deficit or surplus due to factors such as changes in global conditions, international competitiveness, exchange rates

Make a guess

Inflation is rising, and real output is rising too. Which kind of inflation is this more likely to be?

1. Demand-pull, because AD is rising.
2. Neither, because output and prices cannot rise together.
3. Cost-push, because firms' costs are rising.

The answer to part (a)

Introduction

Inflation is a sustained rise in the general price level. It can start on the demand side of the economy, when total spending grows faster than the economy can produce: demand-pull inflation. Or it can start on the supply side, when firms' costs rise: cost-push inflation. Both can be shown on an AD/AS diagram.

Paragraph 2: demand-pull inflation

Demand-pull inflation happens when aggregate demand (AD) rises faster than the economy's capacity to produce. AD can rise because households feel richer and spend more (C), firms invest more (I), the government spends more (G) or foreigners buy more exports (X). In Figure 1, AD shifts right from AD0 to AD1. When the economy has spare capacity, firms can meet the extra demand by producing more. But near full capacity, firms compete for scarce workers, machines and materials, so they bid up wages and prices. AS is steep here, so the price level rises sharply, from P0 to P1, while output rises only a little. When economies reopened after COVID-19 in 2021 and 2022, pent-up spending and government support pushed up demand faster than supply could recover.

Paragraph 3: cost-push inflation

Cost-push inflation happens when firms' costs rise for reasons not caused by higher demand. In 2022, world prices of oil, gas and food jumped after Russia invaded Ukraine. Singapore imports nearly all its energy and most of its food, so firms' costs rose directly. Wages can also push costs up when they rise faster than productivity, as in a tight labour market. Each unit of output now costs more to produce, so firms supply less at each price level and AS shifts up from AS0 to AS1. At E2 the price level rises to P2, while real output falls to Y2. Prices rise even as the economy produces less.

Paragraph 4: how inflation keeps going

Either cause can become a wage-price spiral. When prices rise, workers ask for higher wages to protect their real income. Higher wages raise firms' costs, so firms raise prices again, and the cycle repeats. Expectations matter: if people expect high inflation, they build it into wages and prices, which keeps it going.

Conclusion

Demand-pull inflation comes from AD rising faster than capacity, which raises both prices and output. Cost-push inflation comes from rising costs, such as imported energy or wages, which raise prices while output falls. Either can continue through a wage-price spiral.

Margin notes: how each paragraph scores

Introduction

Defines inflation precisely and names both causes, linking each to one side of the economy.

Paragraph 2

L3 rigour: the components of AD, why prices rise near full capacity, and the movement E0 to E1 on Figure 1. Real context from 2021-22.

Paragraph 3

The second cause with the same depth, using Singapore's import dependence, and E0 to E2 on Figure 1. Contrasting the effect on output shows understanding.

Paragraph 4

Adds how inflation persists through expectations, which helps a script reach the top of L3.

Conclusion

Contrasts the two causes in three sentences. No evaluation marks are available for a 10-mark part.

Overall: L3, 9 or 10 marks

Both causes explained with full chains, a correct diagram and real examples. Only one cause developed would cap the answer at L2.

Worked example: A 3-minute plan

Two causes, two chains, one diagram.

1. Intro: inflation is a sustained rise in the general price level; two causes.
2. Demand-pull: C, I, G or X rise; near full capacity firms compete for scarce resources; E0 to E1.
3. Cost-push: imported energy and food, wages above productivity; AS up; E0 to E2.
4. Link: wage-price spiral can keep either going.
5. Close: demand-pull raises output too; cost-push lowers it.

Watch out for this

Cost-push inflation happens when AD shifts to the right and pushes up costs.

Cost-push starts on the supply side: a rise in costs, such as imported energy or wages, shifts AS up. AD rising is demand-pull, even though it can raise costs later.

Check your understanding

In Figure 1, what is the main difference between E1 and E2?

1. Prices rise at E1 but fall at E2, though output rises in both.
2. E1 shows deflation and E2 shows inflation, since costs are what raise prices.
3. Output rises at E1 but falls at E2, though prices rise in both.