Two economies both report 7% inflation. In one, shops cannot restock fast enough because customers are queuing. In the other, factories are closing because energy has doubled in price. Same number, opposite problems, opposite cures. Diagnosing which one you are looking at is the whole skill here.
📚 What you need to know
Demand-pull inflation comes from rising aggregate demand: AD shifts right, prices and output both rise.
Cost-push inflation comes from rising costs of production: SRAS shifts left, prices rise while output falls.
Output is the giveaway. Rising prices with rising output = demand-pull. Rising prices with falling output = cost-push.
Cost-push produces stagflation: inflation and unemployment rising together.
Costs of inflation fall on savers, people on fixed incomes, firms planning investment, workers, and exporters.
Real values matter: real interest rate ≈ nominal rate − inflation rate; real wage growth ≈ nominal wage growth − inflation.
Demand-side policy treats demand-pull. It treats cost-push badly, because reducing AD makes the output loss worse.
Demand-pull: too much money chasing too few goods
When any component of aggregate demand rises — consumption, investment, government spending or net exports — households and firms want to buy more than the economy can currently produce. Sellers respond in the obvious way: they raise prices.
Common triggers include a cut in interest rates, a tax cut, a consumer confidence boom, a rise in government spending, or a fall in the exchange rate making exports cheaper abroad.
Both arrows point the same way: prices up, output up. Unemployment usually falls at the same time, which is why demand-pull inflation often arrives with good news attached.
Cost-push: it costs more to make everything
Now suppose demand is unchanged but production gets more expensive. Wages rise faster than productivity, oil prices spike, a currency falls and makes imported components dearer, or a supply chain breaks. Firms face higher costs at every level of output, so short-run aggregate supply shifts left.
This is stagflation in one picture: the price level climbs from AP1 to AP2 while output slides from Y1 back to Y2, so unemployment rises at the same time.
The two-second diagnosis. Ask what happened to real output. Up with prices means the cause was demand. Down with prices means the cause was supply. If an extract gives you GDP growth alongside the inflation figure, it has handed you the answer.
When inflation feeds itself
Both types can become self-sustaining through a wage-price spiral. Prices rise, so workers ask for higher wages to protect their real income. Higher wages raise firms’ costs, so firms raise prices again, so workers ask again. Expectations become the cause.
This is why central banks talk so much about “anchoring expectations”. If everyone believes inflation will be 2% next year, they build 2% into wage deals and price lists, and the belief helps make itself true. Credibility is a real policy tool, not just talk.
Who inflation hurts, and why
Group
How inflation damages them
Savers
If the interest rate on savings is below inflation, the real value of savings falls every year even though the balance grows.
People on fixed incomes
Pensions and benefits that are not index-linked buy less each year, so living standards fall automatically.
Workers
Real wages fall unless pay rises match inflation. Bargaining takes time, so there is usually a lag during which people are worse off.
Firms
Uncertainty delays investment; menu costs of repricing; shoe-leather costs of managing cash more actively.
Exporters
If domestic prices rise faster than competitors’ prices, exports become less competitive and net exports fall.
Government
Index-linked spending rises; the trade-off between fighting inflation and protecting jobs becomes politically painful.
Borrowers
The one group that gains: the real value of a fixed debt falls as prices rise, so debt is repaid in cheaper money.
Getting to real values
Real interest rate ≈ nominal interest rate − inflation rate
Real wage growth ≈ nominal wage growth − inflation rate
WORKED EXAMPLE
A saver earns 3% interest while inflation is 7%. A worker gets a 4% pay rise in the same year. Calculate what happens to each in real terms. [3]
Step 1: the saverReal interest rate = 3% − 7% = −4%The balance grows, but it buys 4% less than last year.Step 2: the worker, using the approximation4% − 7% = −3%Step 3: the exact version(1.04 ÷ 1.07) − 1 = −0.0280Saver −4%, worker about −2.80% in real termsThe approximation is fine at low inflation. Use the exact ratio when inflation is high, and say which you used.
Choosing the right policy
The whole reason we bother classifying inflation is that the cure has to match the cause.
Doing nothing lets a wage-price spiral start and expectations become unanchored
Cost-push
Supply-side policy: raise productivity, improve competition, reduce reliance on the input that spiked
Using contractionary demand policy cuts inflation but deepens the fall in output, making unemployment much worse
Supply-side policies are the right answer for cost-push but they are slow. Training a workforce or building an energy network takes years, while the price of oil moves in a week. That timing mismatch is a strong evaluation point in any essay.
WORKED EXAMPLE
An extract reports inflation rising from 2% to 8% while real GDP fell by 1% and unemployment rose. Identify the type of inflation and justify your answer. [4]
Step 1: read the output signal
Real GDP fell and unemployment rose while prices rose.
Step 2: match it to a diagram
Only a leftward shift of SRAS raises the price level and lowers output at the same time. A rightward AD shift would raise both.
Step 3: name it and give a likely triggerCost-push inflation, probably from higher energy or imported input pricesCost-push inflation, evidenced by stagflationFinish with policy: raising interest rates here would cut inflation but push output down further.
💡 Exam tip
Draw the diagram that matches the cause, and shift only one curve. Shifting both muddies the analysis and loses marks.
Always say what happened to output and employment, not just prices. That is where the analysis marks live.
Use the word real whenever you talk about savings, wages or interest. Nominal figures on their own prove nothing.
Name a specific trigger from the extract — an oil price rise, a wage settlement, a tax cut — rather than saying “costs rose”.
Balance the evaluation: borrowers gain, exporters with a weaker currency may gain, and mild inflation supports employment.
If the question mentions stagflation, that is a direct instruction to draw a leftward SRAS shift.
⚠ Common mix-up
Shifting AD for a cost shock. An oil price rise moves SRAS, not AD.
Thinking all inflation is bad. The target is 2%, not 0%. Low stable inflation is a sign of a healthy economy.
Forgetting that inflation redistributes. It transfers real wealth from lenders and savers to borrowers.
Ignoring the exchange rate channel. A depreciating currency raises import prices and is a very common cost-push trigger.
Assuming higher wages always cause inflation. If wages rise in line with productivity, unit labour costs do not rise at all.
Prescribing higher interest rates for every inflation question. For cost-push that treatment can be worse than the disease.
Up next: Deflation and Disinflation — what happens when the price level starts moving the other way, and why economists fear it more than mild inflation.
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