- The Cost-Push Inflation (Explained With Diagram)
- Wage-Push Inflation:
- Profit-Push Inflation:
- Difference Between Demand-Pull and Cost-Push Inflation (with Comparison Chart)
- Content: Demand-Pull Inflation Vs Cost-Push Inflation
- Comparison Chart
- Definition of Demand-Pull Inflation
- Definition of Cost-Push Inflation
- Cost-Push Inflation
- Diagram Showing Cost-Push Inflation
- Causes of Cost-Push Inflation
- Cost-Push Inflation – Temporary or Permanent?
- Measures of Inflation
- Policies to Reduce Cost-Push Inflation
- Cost Push Inflation (Definition, Effects) | Top Causes of Cost Push Inflation
- #1 – Wage push inflation
- #2 – Profit push inflation
- #3 – Material
- Measures to Control Cost-Push Inflation
- Recommended Articles
- Demand-Pull and Cost-Push Inflation
- Demand-Pull Inflation
- Cost-Push Inflation
The Cost-Push Inflation (Explained With Diagram)
We can visualise situations where even though there is no increase in aggregate demand, prices may still rise. This may happen if there is increase in costs independent of any increase in aggregate demand.
Three such autonomous increases in costs which generate cost-push inflation have been suggested. They are:
1. Wage-push inflation
2. Profit push inflation
3. Increase in prices raw materials, especially energy inputs such as rise m crude oil prices.
It may be noted that rise in prices of raw materials, especially of energy inputs (petroleum products) which have a cost push effect are also called supply shocks.
We discuss these below:
It has been suggested that the growth of powerful trade union is responsible for the spread of inflation, especially in the industrialized countries. When trade unions push for higher wages which are not justifiable either on grounds of a prior rise in productivity or of cost of living they produce a cost-push effect.
The employers in a situation of high demand and employment are more agreeable to concede to these wage claims because they hope to pass on these rises in costs to the consumers in the form of hike in prices.
If this happens we have cost-push inflation.
It may be noted that as a result of cost-push effect of higher wages, aggregate supply curve of output shifts to the left and, given the aggregate demand curve, this results in higher price of output.
Besides the increase in wages of labour without any increase in its productivity, there is another factor responsible for cost-push inflation. This is the increase in the profit margin by the firms working under monopolistic or oligopolistic conditions and as a result charging higher prices from the consumers.
In the former case when the cause of cost-push inflation is the rise in wages it is called wage-push inflation and in the latter case when the cause of cost-push inflation is the rise in profit margins, it is called profit-push inflation. The increase in profit margins also produces a cost-push effect and results in shift in the aggregate supply curve to the left.
Rise in Raw material Prices or Oil Price Shock:
In addition to the rise in wage rate of labour .crease in profit margins, in the seventies the other supply-shocks causing increase in marginal cost of production became more prominent in bringing about cost-push inflation.
During the seventies in prices of raw materials, especially energy inputs (hike in crude oil price made by OPEC resulting in rise in prices of petroleum products).
The sharp rise in world oil prices during 1973-75 and again in 1979-80 produced significant supply shocks resulting in cost-push inflation.The cost-push inflation can also be illustrated with the aggregate demand and supply curves. Consider Fig. 23.
3, where aggregate supply and demand are measured along the X-axis and price level along the Y-axis. AD is the aggregate demand curve and AS1 and AS2 curves are aggregate supply curves.
Now, when wages increase, and as a result cost of production rises, the aggregate supply curve would shift upward to the left. As will be seen in Fig. 23.3 when there is an upward shift in the aggregate supply curve from AS1 to AS2 due to the rise in wages, price level rises from OP1 to OP2.
Thus, in this case when aggregate demand curve remains the same, price level rises due to rise wages which has caused leftward shift in the supply curve. An important feature of cost-push inflation is that this causes not only rise in price level but brings about a fall in aggregate output. Thus in Fig. 23.3 when price level rises from OP1 to OP2 aggregate output falls from OY1 to OY2.
Indirect Effect of Increase in oil prices or other raw material prices. In addition to the direct effect of oil price shocks and increase in other raw material prices, there are indirect effects of such supply shocks which cause further rise in rate of inflation. It may be noted that an aggregate supply curve is drawn assuming given price level expectations over time.
When a certain event occurs, the workers will revise their price expectations. Now, when due to increase in raw material prices or oil price shock price level of output has risen as a result of cost-push effect, the workers would revise upward their expectations of price level.
With this, the expected real wage rate (W/P) will decline and therefore less labour will be supplied at a given money wage rate.
Thus, with the increase in expected price level, aggregate supply curve will further shift to the left as a result of this indirect effect through the upward revision of expected price level.This indirect effect is illustrated in 23.4.
Initially, aggregate demand curve AD and aggregate supply curve AS1 (with P1 as the expected price level) determine price level and P1output Y1. Now, due to oil price shock, aggregate supply curve shifts to the left to AS2 (P1) and price level rises to P2.
Since price level has risen, workers will adjust the expected price level upward say to P2. The causes a further shift in the aggregate supply curve to AS3 (P2) and further in price level to P3.
Interaction between Demand-Pull and Cost-Push Inflation:
Many economists think inflation in the economy is generally caused by the interaction of the demand pull and cost-push factors. The inflation may be started in the first instance either by cost-push factors or by demand pull factors both work and interact to cause sustained inflation over time.
Thus, according to Machlup, “there cannot be a thing as cost push inflation because without an increase in purchasing power and demand, cost increases will lead to unemployment and depression, not to inflation” wise, Cairncross writes, “there is no need to pretend that demand and cost inflation do not interact or that excess demand does not aggregate wage inflation, of course it does.”
We will explain this interaction, first with inflationary process starts with cost push factor and then secondly when inflation begin with shift in aggregate demand. In both cases rate of inflation over time is the result of interaction of demand-pull and cost-push factors.1. Let us consider the Figure 23.
5 where to begin with aggregate demand curve AD and aggregate supply curve AS intersect at point E0 and determine price level P0 and output level Y0. Further suppose that Y0 is the full capacity (i.e., full-employment) level of output and therefore long-run aggregate supply curve LAS is vertical at Y0 level of output.
Suppose there is increase in oil prices which causes shifts in aggregate supply curve to the left from AS to AS’1.
As a result, price level rises to P1 but output falls from Y0 to T1. With decline in output unemployment will also increase. This is a cost-push inflation which has caused recessionary conditions in the economy. The Government and Central Bank are ly to adopt expansionary monetary and fiscal policies in order to avoid recession.
Consequent to the adoption of expansionary policies, (for example, increase in money- supply or increase in Government expenditure or reduction in taxes), aggregate demand curve will shift to the right, say to AD1 which intersects AS1 curve and LAS curve at point E2.
Though as a result of this accommodatary policy while output level has increased to the original full capacity level Y0 price level has further risen to P2 level. This later rise in price level from P1 to P2 is the result of demand-pull Inflation. It is thus clear that both cost-push and demand -pull inflation interact to cause inflation in the economy.
2. Let us now explain inflationary process which starts with demand-pull inflation in the first instance. Consider Figure 23.6. Where to begin with aggregate demand curve AD0 and aggregate supply curve AS0 intersect at E0 and determine level of price P0 and aggregate output Y0.
Assume long-run aggregate supply curve LAS also passes through point E0 so that equilibrium level of output Y0 also represents full-employment level of output (that is, at K0 only natural unemployment exists) and price level P0 also represents long-run equilibrium price level.
Now suppose due to increase in Government expenditure financed by creation of new money aggregate demand curve shifts from AD0 to AD1. The new aggregate demand curve AD, intersects the short-run aggregate supply curve AS0 at point E1.
As a result, in the short run price level rises to P1 and output to Y1.
It may be recalled, short-run aggregate supply curve is drawn assuming a given expected price level by the workers which is usually the price level prevailing in the last few years which is here taken to be P0. Now that as a result of increase in aggregate demand price level has actually risen to P1, workers’ real wages would decline.
Therefore, in order to restore their real wages, they would demand higher money wages. When their demands for higher wages are conceded to, short-run aggregate supply curve will shift to the left. With this leftward shift in the aggregate supply curve, price level will rise further.
In this way wage-price spiral will go on operating until short-run aggregate supply curve shifts to the level AS2 and together with aggregate demand curve AD1 determine a long-run equilibrium at point E2.
It will be seen that both demand-pull inflation and cost-push inflation have operated together to raise price level from P0 to P2.
To conclude, demand-pull inflation and cost-push inflation are intertwined and operate together to determine rate of inflation over time. It is difficult to say in actual practice what part of inflation is due to demand-pull factors and what due to cost-push factors, though, as seen above, theoretically speaking, we can distinguish between demand-pull and cost-push inflation.
Difference Between Demand-Pull and Cost-Push Inflation (with Comparison Chart)
Inflation refers to the rate at which the overall prices of goods and services rises resulting in the decrease in the purchasing power of the common man, which can be measured through Consumer Price Index.
Modern analysis of inflation revealed that it is mainly caused either by demand side or supply side or both the factors.
Demand side factors result in demand-pull inflation while supply side factors lead to cost-push inflation.
The demand-pull inflation is when the aggregate demand is more than the aggregate supply in an economy, whereas cost push inflation is when the aggregate demand is same and the fall in aggregate supply due to external factors will result in increased price level. This article explains clearly the significant difference between demand-pull and cost-push inflation.
Content: Demand-Pull Inflation Vs Cost-Push Inflation
- Comparison Chart
- Key Differences
|Meaning||When the aggregate demand increases at a faster rate than aggregate supply, it is known as demand-pull inflation.||When there is an increase in the price of inputs, resulting in decrease in the supply of outputs, is is known as cost-push inflation.|
|Represents||How price inflation begins?||Why inflation is so difficult to stop, once started?|
|Caused by||Monetary and real factors.||Monopolistic groups of the society.|
|Policy recommendations||Monetary and fiscal measures||Administrative control on price rise and income policy.|
Definition of Demand-Pull Inflation
Demand Pull Inflation arises when the aggregate demand goes up rapidly than the aggregate supply in an economy. In simple terms, it is a type of inflation which occurs when aggregate demand for products and services outruns aggregate supply due to monetary factors and/or real factors.
- Demand-Pull Inflation due to monetary factors: One of the major cause of inflation is; increase in money supply than the increase in the level of output. The German inflation, in the year 1922-23 is the example of Demand-Pull Inflation caused by monetary expansion.
- Demand-Pull Inflation due to real factors: When the inflation is due to any one or more of the following reasons, it is said to be caused by real factors:
- The increase in government spending without the change in tax revenue.
- Fall in tax rates, with no change in government spending
- Increase in investments
- Decrease in savings
- Increase in exports
- Decrease in imports
these six factors, the first four factors, will result in the rise in the level of disposable income. The increase in aggregate income result in the increase in aggregate demand for goods and services, causing demand-pull inflation.
Definition of Cost-Push Inflation
Cost push inflation means the increase in the general price level caused by the rise in prices of the factors of production, due to the shortage of inputs i.e. labour, raw material, capital, etc. It results in the decrease in the supply of outputs which mainly use these inputs. So, the rise in prices of the goods emerges from the supply side.
Moreover, cost-push inflation may also be caused by depletion of natural resources, monopoly and so on. There are three kinds of cost-push inflation:
- Wage-push inflation: When the monopolistic groups of the society labour union exercise their monopoly power, to enhance their money wages above the competitive level, which cause an increase in the cost of production.
- Profit-push inflation: When the monopoly power is used by the firms operating in the monopolistic and oligopolistic market to increase their profit margin, leading to rise in the price of goods and services.
- Supply shock inflation: A type of inflation arising due to unexpected fall in the supply of necessary consumer goods or major industrial inputs.
The differences between dDemand-pull and cost-push inflation can be drawn clearly on the following grounds:
- Demand-pull inflation arises when the aggregate demand increases at a faster rate than aggregate supply. Cost-Push Inflation is a result of an increase in the price of inputs due to the shortage of cost of production, leading to decrease in the supply of outputs.
- Demand-pull inflation describes, how price inflation begins? On the other hand, cost-push inflation explains Why inflation is so difficult to stop, once started?
- The reason for demand-pull inflation is the increase in money supply, government spending and foreign exchange rates. Conversely, cost-push inflation is mainly caused by the monopolistic groups of the society.
- The policy recommendation on demand-pull inflation is associated with the monetary and fiscal measure which amounts to the high level of unemployment. Un, cost push inflation, where policy recommendation is related to administrative control on price rise and income policy, whose objective is to control inflation without increasing unemployment.
Therefore, you can conclude with the above discussion the main reason for causing inflation in the economy is either by demand-pull or cost-push factors.
It is often argued that which is the supreme factor for inflation, which one of the two-factor causes rise in the general price level for the first time.
Experts hold that demand-pull factor the leading factor for inflation in any economy.
Definition: Cost-push inflation occurs when we experience rising prices due to higher costs of production and higher costs of raw materials. Cost-push inflation is determined by supply-side factors, such as higher wages and higher oil prices.
Cost-push inflation is different to demand-pull inflation which occurs when aggregate demand grows faster than aggregate supply.
Cost-push inflation can lead to lower economic growth and often causes a fall in living standards, though it often proves to be temporary.
Diagram Showing Cost-Push Inflation
Short-run aggregate supply curve shifts to the left, causing a higher price level and lower real GDP.
Causes of Cost-Push Inflation
- Higher Price of Commodities. A rise in the price of oil would lead to higher petrol prices and higher transport costs. All firms would see some rise in costs. As the most important commodity, higher oil prices often lead to cost-push inflation (e.g. 1970s, 2008, 2010-11)
- Imported Inflation.
A devaluation will increase the domestic price of imports. Therefore, after a devaluation, we often get an increase in inflation due to rising cost of imports.
- Higher Wages. Wages are one of the main costs facing firms.
Rising wages will push up prices as firms have to pay higher costs (higher wages may also cause rising demand)
- Higher Taxes. Higher VAT and Excise duties will increase the prices of goods. This price increase will be a temporary increase.
- Profit-push inflation.
If firms gain increased monopoly power, they are in a position to push up prices to make more profit
- Higher Food Prices. In western economies, food is a smaller % of overall spending, but in developing countries, it plays a bigger role.
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.
Cost-Push Inflation – Temporary or Permanent?
This shows two periods of cost-push inflation in the UK – 2008 and 2011. These periods of cost-push inflation proved relatively temporary because the economy was in recession.
Many cost-push factors rising energy prices, higher taxes, and the effect of devaluation may prove temporary. Therefore, Central Banks may tolerate a higher inflation rate if it is caused by cost-push factors. For example, in 2011, CPI inflation reached 5%, but the Bank of England kept base rates at 0.5%. This showed the Bank of England felt underlying inflationary pressure were low.
Different measures of inflation indicate cost-push inflation
In 2011, CPI inflation reached 5%, however, if we exclude the effect of taxes (CPI-CT) inflation was 3%. If we also excluded the effect of higher import prices (from devaluation) inflation would have been even lower.
Other economists may fear that temporary cost push factors may influence inflation expectations. If people see higher inflation, they may bargain for higher wages and thus the temporary cost-push inflation becomes sustained.
In the 1970s, there is evidence that temporary cost-push inflation fed into permanently higher inflation. This is partly because workers demanded higher wages in response to growing inflation.
Inflation of the 1970s.
In the 1970s, inflation was caused by the rapid rise in oil prices, and also rising nominal wages. Workers had greater bargaining power to demand higher wages.
Measures of Inflation
Some measures of inflation seek to avoid ‘temporary cost-push factors’ For example, CPI-Y excludes the effect of taxes. ‘Core inflation’ seeks to measure inflation by ignoring volatile factors such as commodities and energy.
Policies to Reduce Cost-Push Inflation
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 the 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 targeting. 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.
from: Economic policies to reduce inflation
Cost Push Inflation (Definition, Effects) | Top Causes of Cost Push Inflation
Cost-push inflation is the form of inflation that is caused as a result of substantial increment in the cost of the factors of production raw materials, labor, factory rent, etc and the same cannot be altered as this literally has no appropriate alternative and this ultimately leads to a decrease in the supply of these inputs.
#1 – Wage push inflation
One of the causes of cost-push inflation is when the increase in the wages of labour is more than the increase in their productivity at work. Since the labourers have to be paid more, the producers increase the price of finished goods to pass on the hike in production cost that eventually results in inflation. This type of inflation is usually seen when there is a strong labor union.
Let us take the example of a company wherein the workers are producing 100 units annually and their wages are fixed at $20 per hour.
Now, let us assume that the labor union has demanded a hike in the wage by 25% and consequently the company has increased the wage to $25 per hour. However, the production output has increased from 100 units to 110 units annually.
As such, there is a difference between the rise in production output (10%) and a rise in wages (25%) which is known as wage-push inflation.
#2 – Profit push inflation
The causes of cost-push inflation are when entrepreneurs or producers increase the prices of goods and services more than the popular expectation in order to garner a higher profit margin that again leads to inflationary conditions.
Let us take an example where the senior management of a company has decided to increase the price of its product from $200 to $230 although there is no corresponding increase in the price of inputs and wages. It can be seen that there is a 15% rise in profit leading to inflation and as such this type of inflation is known as profit-push inflation.
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#3 – Material
Another major cause of cost-push inflation is when there is an increase in the prices of some key materials (such as steel, energy, oil, etc.
) which are used, either directly or indirectly, in almost the entire economy.
Consequently, an increase in the prices of such material significantly influences the cost structure of all industries and eventually the economy ends up in the clutches of inflation.
The supply shock created by the Organization of the Petroleum Exporting Countries (OPEC) four decades ago is a classic example of material cost-push inflation. The organization intended to decrease the global oil supply by raising the prices that resulted in a sharp increase in inflation that eventually led to a supply shock.
Besides, some other causes of inflation can be natural disasters and government regulations.
A good example of inflation caused by the natural disaster is Hurricane Katrina that created havoc in the US in the year 2005 as the storm destroyed oil refineries that led to soaring of gas prices.
On the other hand, an example of inflation due to government regulation is a tax on cigarettes and alcohol which leads to the increased price of these products and hence inflation.
It is important to understand that inflation per se is not such a bad thing. However, the inflation caused by cost-push inflation is somewhat the wrong kind of inflation. Cost-push inflation is characterized by rising prices and falling real GDP.
The fall in real GDP despite an increase in the overall price level is indicative of the fact that the productivity level of the economy is deteriorating.
Further, cost-push inflation also affects employment as the decline in real GDP results in decreased demand for goods and services that then compels firms to lay off workers and decreasing the employment. As such, this type of inflation results in a fall in living standards.
Measures to Control Cost-Push Inflation
Most often governments intend to implement a deflationary fiscal policy such as higher taxes, lower spending, etc. while central banks tend to increase the interest rates.
Both measures are expected to increase the cost of borrowing which is then ly to cut down consumer spending and investment.
However, the problem with higher interest rates is that even though it is ly to reduce the inflation rate, it has the potential to result in a big fall in the GDP.
As such, a better long term solution to cost-push inflation can be an implementation of improved supply-side policies that are expected to increase productivity. However, the problem with this solution is that such policies are ly to take a long time to have any effect on the economy.
This has been a guide to what is Cost-Push Inflation. Here we discuss its effects along with 3 major causes for the increase in costs that generate Cost-Push Inflation. We also discuss the measures to control Cost-Push Inflation. You can also go through our other suggested articles –
- Aggregate Supply
- GDP vs GNP
- Inflation vs Deflation
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Demand-Pull and Cost-Push Inflation
The term ‘inflation’ is used in many senses and it is difficult to give a generally accepted, precise and scientific definition of the term. Popularly, inflation refers to a rise in price level.
We can distinguish between two kinds of inflation on the basis of their causes, viz., demand-pull and cost-push inflation.
The most common cause for inflation is the pressure of ever-rising demand on a stagnant or less rapidly increasing supply of goods and services. The expansion in aggregate demand may be due to rapidly increasing private investment or expanding government expenditure for war or economic development.
At a time when demand is expanding and exerting pressure on prices, attempts are made to expand production. However, this may not be possible either due to non- availability of employed resources or shortages of transport, power, capital and equipment.
Expansion in aggregate demand, after the level of full employment, results into rise in the price level. In a developing economy India, resources are used for growth, for creating fixed assets and production of consumer goods. Necessarily, large expenditure will create.
large money income and large demand but without a corresponding increase in supply of real output.
In the above diagram, an increase in aggregate demand (AD) from AD1 to AD2 leads to a rise in the general price level (P) from P1 to P2. Aggregate demand could increase due to an increase in any of its components.
For instance, when households are more optimistic about the economic outlook, they will expect their income to rise and hence increase consumption expenditure. Consumption expenditure may also rise due to other factors such as an increase in the wealth of households.
A fall in interest rates will lead to more profitable planned investments resulting in an increase in investment expenditure. Investment expenditure may also rise due to other factors such as stronger business sentiment.
When the economy is in a recession, the government may increase expenditure on goods and services to steer the economy back onto the path of expansion. An increase in foreign income will lead to an increase in net exports.
We should emphasize here the role played by deficit financing and increase in money supply on the level of prices in a developing country. Often, the government of a developing country resorts to deficit spending to finance economic development i.e.
, borrowing from the central bank and commercial banks, which, in turn, leads to increase in money supply in the country. This exerts a strong pressure on the level of prices. An increase in foreign demand for the exports of a country may also raise the price level in a country.
Expansion in foreign demand and consequent expansion in exports will raise income of the people. This will push up demand for goods and services within a country. In case the additional money income is used to buy imports or is hoarded then it will not have inflationary effect in the country.
Thus, inflationary pressure is built by increasing aggregate demand in excess of the available resources. The increase in aggregate demand can be due to increase in government expenditure or increase in private investment and private consumption or release of pent up demand of consumers immediately after a war or increase in exports and so on.
Deficit financing and increase in money supply further aggregate the situation by boosting demand still further. In all these cases, inflation is the result of demand-pull factors. It must be emphasized here that demand-pull inflation cannot be sustained unless there is increase in money supply.
In certain circumstances, prices are pushed up by wage increases, forced upon the economy by labor leaders under the threat of strike. Costs can also be raised by manufacturers through a system of fixing a higher margin of profit.
The common man generally blames profiteers, speculators, hoards and others for pushing up the costs and prices. Again, the government is responsible for raising the costs by imposing new taxes and continuously raising the tax rates of existing commodity.
Therefore, rising rates of commodity taxes, in a sellers market, will enable the producers to raise the prices by the full amount of taxes.
Under conditions of rising prices, business and industrial units find it easy to pass on the burden of higher wages to the consumers by raising the prices. Thus rise in wages, profit margin and taxation are responsible for cost-push inflation.
In the above diagram, a decrease in aggregate supply (AS) from AS1 to AS2 leads to a rise in the general price level (P) from P1 to P2. The cost of production in the economy may rise independently of demand due to several reasons. For instance, workers will bargain for higher wages when they expect prices to rise or when the labour market is tight.
The prices of imported intermediate goods will rise when the exchange rate of domestic currency falls or when there is inflation in other economies. If the government increases indirect taxes such as the goods and services tax or if oil prices rise, the cost of production in the economy will rise.
For instance, the sharp rise in oil prices in the early 1970s led to a huge rise in the cost of production in the world.
In periods when wages, prices and aggregate demand are all rising and creating an inflationary situation, it is difficult to find out active and passive factor. In many cases, it is neither demand-pull inflation nor cost-push inflation, but it is a combination of both. However, it is possible and often useful to separate the dominant factors.
If aggregate demand is responsible for the inflationary situation, it may persist so long as excess demand persists and in the extreme case, it may develop into hyper-inflation come though cost-push inflation. On the other hand, cost-push inflation cannot persist for long, unless there is increase in aggregate demand.
On the other hand, if wages and prices continue to rise even when demand ceases to grow, we have cost-push inflation.