1. Demand-pull factors
The demand-pull factor causes the aggregate demand (AD) to rise at a certain price level in the economy. This surplus of demand with a certain supply of services and goods results to a rise in the prices. Furthermore, when the economy reaches full employment level of output, leads to an increase in AD will lead to a rise in the prices.
According to Keynesians the long run aggregate supply (LRAS) curve is horizontal, upward sloping, and then vertical. The increasing level of demand is ‘pulling’ the prices high, hence the name ‘demand-pull’ inflation. There can be numerous circumstances in which the full employment in an economy excess of AD over the existing supplies of services and goods.
During wars majority of the resources are used leading to a rise in income and a rise in demand. On the contrary, the supply of consumer services and goods falls significantly as many resources are averted in the production of war equipment.
This excess of AD over AS results to a sharp rise in the price level. The government can stop this rise in price level with the help of controlling the price and rationing ‘Demand-pull inflation”. Demand-pull inflation happens when at full employment the government expenditure rises and is fuelled through borrowing from the central bank. The government spending increases the income level in the economy initiating the demand for services and goods to rise.
2. Cost-push factor
The cost-push factor is an increase in the production cost leading to the decline of aggregate supply (AS). This factor increases the costs of production resulting in a decrease in the profits of the producers. As a result, the producers increase the prices of services and good to shift partially or completely of the increased cost of production on the consumers. On the other hand, producers decrease the output of goods and services.
Cost inflation arises when the price level of an imported raw material increase along with the increase in the cost of production. This could be a result of an increase in the global price of raw material or because of depreciation of the local currency which has caused the imported raw material to be expensive in relation to the local currency.
Furthermore, devaluation in the exchange rate is also the cause of inflation. Devaluation will lead to an increase in the price of imports which will be sold to the consumers. Moreover, there will be a rise in the exports resulting in higher aggregate demand.
A rise in the wages without a rise in the productivities of labor will result in cost-push inflation. The producer will pass the burden of increased price on the consumer by increasing the prices of goods and services.
An indirect tax increase is also an essential cause of cost-push inflation. Value-added tax (VAT) is a kind of indirect tax which is imposed on services and goods which increases the cost of production and producers pass the tax partially or completely on consumers as increased prices.