Chapter 10 · Macroeconomic objectives I: Low unemployment, low and stable rate of inflation
Cost-push inflation
Show how higher production costs shift SRAS left, raising the price level and reducing real GDP. Explain cost-push inflation and stagflation.
The economic idea
Inflation is a sustained increase in the general price level, not merely a high price level or a rise in the price of one product.
Cost-push inflation occurs when economy-wide production costs rise or an adverse supply shock reduces short-run aggregate supply. Firms are then willing and able to produce less at every average price level.
Possible causes include higher nominal wages not matched by productivity, rising energy or raw-material costs, currency depreciation that makes imported inputs dearer, higher indirect taxes and supply-chain disruption.
Because an adverse SRAS shift raises the price level while lowering real output, it can create stagflation: inflation combined with weak output and rising cyclical unemployment.
Continuing cost-push inflation requires persistent or repeated cost pressure, wage–price feedback or expectations that become embedded. A single supply shock produces a one-time price-level increase in the static diagram.
Reading the current supply-side movement from SRAS₁ to SRAS₂
“Price level” measures the general price level and “Real GDP” measures real GDP. Inflation is inferred from a rise in the price level over time, not from its absolute height.
“SRAS₁” is the original production schedule, “SRAS₂” is the current schedule, and “AD” is held fixed.
“E₁” records the initial price level “P₁” and output “Q₁”. “E₂” records the new price level “P₂” and output “Q₂” when the curves are distinct.
Starting equilibrium: E₁
“E₁” is where “AD” intersects “SRAS₁” before the shock.
The causal change: SRAS₁ to SRAS₂
“SRAS₂” lies to the left/above “SRAS₁”. The price level rises from “P₁” to “P₂”, while real GDP falls from “Q₁” to “Q₂”.
What the price-level movement means
The current state is consistent with cost-push inflation and stagflation: an adverse supply shift raises the price level while reducing real output.
Why demand management faces a trade-off
An adverse cost shock can raise prices while reducing output. Increasing AD to support employment may add to price pressure; reducing AD to limit inflationary pressure may deepen the output loss.
An evaluation should identify the source and likely duration of the cost increase. Policies that ease the cost problem may address both objectives, but their effectiveness and speed depend on the cause.
From higher unit costs to cost-push inflation
A non-price production determinant changes unit costs, moving short-run aggregate supply from “SRAS₁” to “SRAS₂”.
At “P₁”, firms are willing to produce less than before, creating upward pressure on prices and downward pressure on output.
The economy moves along the unchanged “AD” until it reaches “E₂”.
“SRAS₂” lies to the left/above “SRAS₁”. The price level rises from “P₁” to “P₂”, while real GDP falls from “Q₁” to “Q₂”. The current state is consistent with cost-push inflation and stagflation: an adverse supply shift raises the price level while reducing real output.
Common mistakes to avoid
- Cost-push inflation is caused by a left/upward shift of SRAS, not by movement along SRAS.
- The fall in output is movement along “AD”; aggregate demand has not shifted in this isolated model.
- Stagflation is the combination of inflation with weak output and unemployment, not simply a high price level.
- Contractionary demand policy may reduce inflation but can deepen the output loss caused by an adverse supply shock.
How to draw this diagram
- Title the diagram “Cost-push inflation”. Label the horizontal axis “Real GDP” and the vertical axis “Price level”.
- Draw AD first and label it clearly.
- Draw SRAS₁ next and label it clearly.
- Draw SRAS₂ next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The diagram shows a one-time price-level increase; continuing inflation requires persistent cost pressure or repeated shocks.
- Temporary shocks may reverse without producing a lasting inflation process.
- Firms can absorb some costs through lower profit margins instead of passing all of them into prices.
- Demand management faces a trade-off because lower inflation can come with still weaker output and employment.
- The aggregate model hides uneven cost exposure across sectors and households.