Cost Push Inflation

Readers Question: But these are mostly the solutions to demand-pull inflation. What about imported and cost-push inflation?

from: Economic Policies to reduce inflation

Cost push inflation could be caused by a rise in oil prices or other raw materials. Imported inflation could occur after a depreciation in the exchange rate which increases the price of imported goods.

Policies to reduce cost push inflation are essentially the same as policies to reduce demand pull inflation.

The government could pursue deflationary fiscal policy (higher taxes, lower spending) or monetary authorities could increase interest rates. This would increase cost of borrowing and reduce consumer spending and investment.

The problem with using higher interest rates is that although it will reduce inflation it could lead to a big fall in GDP.

For example, in early 2008, we had a high period of inflation (5%) due to rising oil and food prices. Central banks kept interest rates high, but this pushed the economy into recession. Arguably, interest rates should have been lower and less importance attached to reducing cost push inflation.

In 2010, we might see a period of cost push inflation, but, the Central Bank may need to adopt a certain flexibility in inflation targetting. There is no point in rigidly sticking to an inflation target if the inflation is caused by temporary factors.

The long term solution to cost push inflation could be better supply side policies which help to increase productivity and shift the AS curve to the right. But, these policies would take a long time to have an effect.