Distinguish demand-pull from cost-push inflation, explain how inflation is measured, and evaluate its consequences

What this dot point is asking

SEAB wants you to distinguish demand-pull from cost-push inflation using AD-AS, explain how inflation is measured, and evaluate its consequences. The central insight is that inflation has two distinct causes that call for different policies, and that its costs depend on its rate, whether it is anticipated, and which cause is at work.

The answer

What inflation is and how it is measured

Inflation is a sustained rise in the general price level, which reduces the purchasing power of money. It is measured by the percentage change in a price index, usually the Consumer Price Index (CPI):

• A representative basket of goods and services is chosen, reflecting typical household spending.
• Each item is weighted by its share of spending.
• The change in the weighted cost of the basket between periods is the inflation rate.

Limitations: the basket can become outdated, quality changes are hard to capture, and a single national figure hides differences between households. Disinflation is a fall in the inflation rate (prices still rising, but slower); deflation is a falling price level (negative inflation).

Demand-pull inflation

Causes are anything that raises AD near capacity: rapid growth in consumption, investment, government spending or net exports, or overly loose monetary or fiscal policy.

Cost-push inflation

Causes include wage rises above productivity, higher raw material or energy prices, a depreciation that raises import costs, and higher indirect taxes.

Consequences of inflation

High or accelerating inflation is costly:

• Falling purchasing power, hitting those on fixed incomes and savers hardest.
• Loss of international competitiveness if domestic inflation exceeds trading partners', worsening net exports (unless offset by a depreciating currency).
• Uncertainty that deters investment and planning.
• Menu costs (changing prices) and shoe-leather costs (economising on money holdings).
• Arbitrary redistribution from lenders to borrowers when inflation is unexpected.

But the costs depend on context: low and stable inflation is normal and not harmful, anticipated inflation is far less damaging than unexpected inflation, and deflation can be worse than mild inflation because it can deepen downturns.

Examples in context

Example 1. Imported inflation in Singapore. As a small, open, import-dependent economy, Singapore is exposed to imported cost-push inflation when global food and energy prices rise or when the currency weakens. This is one reason monetary policy is run through the exchange rate: a stronger currency lowers import prices and helps contain imported inflation, a tool tailored to the open-economy source.

Example 2. A post-pandemic demand and supply squeeze. When economies reopened after pandemic restrictions, a surge in demand met disrupted supply chains and high energy costs, mixing demand-pull and cost-push inflation. Central banks faced exactly the diagnosis problem above, tightening to curb demand while supply constraints eased only gradually, illustrating why both causes and a careful mix matter.

Try this

Q1. Define cost-push inflation. [2 marks]

• Cue. Inflation caused by rising costs of production, shown as a leftward shift of SRAS that raises the price level and lowers output.

Q2. Explain why low and stable inflation is not considered harmful. [3 marks]

• Cue. It is predictable, so households and firms can plan around it; it avoids the dangers of deflation and signals a healthy growing economy, so only high, accelerating or unexpected inflation is seriously damaging.

Q3. Explain why cost-push inflation is harder to tackle than demand-pull. [2 marks]

• Cue. Restraining AD to cut inflation also deepens the output and employment loss that the leftward SRAS shift already caused, so demand-side tools worsen the recession; supply-side measures are needed.