## Wednesday, December 28, 2016

### How to tell cost-push from demand-pull

I looked up cost push inflation graph, for the hell of it.

That one interested me because it says "in fact" but uses pictographs rather than graphs of actual data. I want to call them "pictograms" but Blogger insists I use the word pictographs. These things:

 Source: Demand Pull and Cost Push inflation with examples at FreeEconHelp
The one has two diagonal lines sloping up (from left to right) and one sloping down. The other has two diagonals sloping down and one sloping up. The one shows a change in Aggregate Supply (AS); the other shows a change in Aggregate Demand (AD). In each case there is one arrow between the two diagonal lines, and another arrow beside the vertical axis, near the label that reads "Price Level". All the arrows are pointing up.

Where there are two diagonal lines with an arrow between, we are to understand that the line moves from the lower position to the upper position. The arrow indicates this movement...

Maybe I have something wrong. Notice that the one graph shows

The price level going up as a result of a decrease in AS

and the other shows

The price level going up as a result of an increase in AD
According to the axis labels, the "up" direction means a change in the price level and the "sideways" direction means a change in Real GDP. So I'm thinking the arrow between the AD and the AD' lines should be pointing to the right. And the arrow between the AS and the AS' lines should be pointing to the left. Otherwise all the arrows show price changes and none of the arrows show changes in supply or demand.

I don't think the lines move from the lower position to the upper position. I think the AS line moves leftward to the AS' position, and the AD line moves rightward to the AD' position. But I don't know if I have that right.

In any event, on each graph there are two horizontals that start at an AS:AD intersection and go back to the Price Level axis. These horizontals represent the price level before and after the movement of the diagonal. In each case obviously the price level is higher after the movement. That's how you know there's inflation!

Okay? Now, none of that interests me. None of that is why I'm writing today. I'm writing because I want to talk about the change in the location of the intersection points.

The graphs both show an up arrow beside the Price Level axis, indicating that the intersection moved upward in both cases. That makes sense. The intersection represents the price level achieved by the interaction of supply and demand. And the graphs both show inflation (as opposed to deflation, say) so we would expect to see an increase in the price level as a result of the movement of the diagonal line.

But that's not the interesting thing. The interesting thing is not the upward change of the intersection point, but the sideways change. The sideways change is leftward for the one type of inflation, and rightward for the other. See here:

 The change in Real GDP is in opposite directions for the two types of inflation
The change in Real GDP is leftward for cost-push inflation, and rightward for demand-pull inflation. This is the key difference. In both cases prices go up. The difference between the two types of inflation occurs not in the price level, but in the performance of the economy.

I don't want to suggest that Real GDP must decrease when the inflation is cost-push. Real GDP is generally always going up. So maybe it goes up a little less if the inflation is cost-push, and it goes up a little more if the inflation is demand-pull. That's the real difference to look for, when you want to know whether the inflation is cost-push or demand-pull.

// Related post: The Cost-Push Economy

The Arthurian said...

Did you notice that the FreeEconHelp site attributes inflation to wages? Wages cause cost-push inflation, they say, and wages cause demand-pull inflation. No one ever attributes inflation to the rising cost of finance.

The Arthurian said...

From the related post:

In demand-pull inflation, prices go up because we have more money than we know what to do with. In cost-push inflation, prices go up because we either increase income, or we go under. In times of demand-pull inflation, people have money to burn. In times of cost-push inflation, people have to stretch every dollar.

Demand-pull inflation is associated with good times; cost-push inflation, with hard times.

The Arthurian said...

My red arrows go in the same direction I think the "between the diagonal lines" arrows should go -- left for cost-push, right for demand-pull. In other words, I agree with the "standard" analysis.

But that doesn't mean I'm saying nothing new. My emphasis is different. The standard analysis explains to you how you get cost-push and how you get demand-pull. I'm telling you what to look for, so you can tell if the inflation is cost-push or demand-pull.

I'm not contradicting the standard analysis. I'm using it in a more productive way. And the standard analysis validates what I'm saying.

Gene Hayward said...

Try teaching this to High School students preparing for the Advanced Placement test. :)

I HATE the "UP" arrows to indicate the directional change in demand or supply. That is econ pedagogy malpractice as far as I am concerned.

My students always say the curves shift left or right (I use the price axis as the frame of reference), never Up or Down. This is mostly to cover one aspect of curve shifts---when supply "goes up" you do not want to shift the supply curve "up". Thats backwards.

I do include level of debt as a determinant of Aggregate Demand--Less debt more potential demand, more debt less demand.

With the AD/AS model and high school students one has to "ceterus paribus" the crap out of it because there are so many moving parts.

This does not really address any of your points but I got a chance to vent.

Hope your New Year is starting off well. :)

The Arthurian said...

Happy New Year to you Gene!

"I HATE the "UP" arrows to indicate the directional change in demand or supply. That is econ pedagogy malpractice as far as I am concerned."

Oh good. I got it right, then.

Do you often see the "directional change" arrows pointing up instead of sideways? I figured I just happened to grab bad images... Although I grabbed the one that Google showed as an example. So maybe it is a common error.

"one has to 'ceterus paribus' the crap out of it"

Oh that's a funny way to put it!

"I do include level of debt as a determinant of Aggregate Demand--Less debt more potential demand, more debt less demand."

Yeah. Which is bigger: the cost of existing debt, or the addition to existing debt? If the addition is bigger, the difference is a boost. If the cost is bigger, the difference is a drag.

With the caveat that additions to existing are ultimately self-defeating, because they make existing debt bigger. Debt has nonlinear consequences.