Q.
a) Discuss the difference between demand-pull inflation and wage pull inflation. (10 marks)
b) Discuss how the following policies control the economy situation.
i. Monetary Policy (5 marks)
ii. Fiscal Policy (5 marks)
(20 marks, 2018 Q6)
A.
a) Difference between demand-pull inflation and wage pull inflation.
[In very short explanation, it is like increase in minimum wage. Increase in wage increases price of good and services in the country - this is wage pull inflation.
When there is increase in population or urbanization, industrialization, more people are earning a good living. They are more productive and thus can have more income. This income will increase demand for goods and services. This is demand pull inflation.
While at the same time, production cost goes up due to increase wages. Due to this product cost increase, the supply becomes less per unit of productivity. So, demand increases as less are produced. This is cost-push inflation.
Like what our prime minister Tun Dr Mahathir used to say, it is no point increasing salary when the GDP does not increase. It will increase the price resulting in inflation, but the people do not get better.
Nevertheless, the difference here between demand pull and wage pull inflation is basically the underlying drivers.
In demand pull inflation, the aggregate demand increases due to increase consumption (may be increase in population), which is organic growth in nature, ie more goods are now needed than before. On the contrary, wage pull inflation happens due to just increase in salary to the workers. Due to higher salary, the surplus cash in the economy makes the prices of goods and services go up. There is no actual organic growth. It is just because more cash is after the same amount of goods.
Take an example in new handphone price.
Demand pull inflation - there are more demand for the new handphone - more population/urbanization, thus its price increases as the manufacturer cannot cope with the demand.
Wage pull inflation - there are more cash surplus and the same number of people ungrading to this new handphone. As they have excess cash, they do not mind the price increase. Thus, they just buy the new handphone.]
Demand-pull inflation is asserted to arise when aggregate demand in an economy outpaces aggregate supply. It involves inflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips curve. This is commonly described as "too much money chasing too few goods."[1] More accurately, it should be described as involving "too much money spent chasing too few goods," since only money that is spent on goods and services can cause inflation. This would not be expected to happen, unless the economy is already at a full employment level. It is the opposite of cost-push inflation.
Causes
- There is a quick increase in consumption and investment along with an extremely confident firms.
- There is a sudden increase in exports which might lead to a huge under-valuation of the currency.
- There is a lot of government spending.
- The expectation that inflation will rise often leads to a rise in inflation. Workers and firms will increase their prices to 'catch up' to inflation.
- There is excessive monetary growth, when there is too much money in the system chasing too few goods. The 'price' of a good will thus increase.
- There is a rise in population.
On the other hand Wage-pull inflation is as below.
Wage push inflation is an overall rise in the cost of goods that results from a rise in wages. To maintain corporate profits after an increase in wages, employers must increase the prices they charge for the goods and services they provide. The overall increased cost of goods and services has a circular effect on the wage increase; eventually, as goods and services in the market overall increase, higher wages will be needed to compensate for the increased prices of consumer goods.
Companies can increase wages for a number of reasons. The most common reason for raising wages is an increase to the minimum wage. The federal and state governments have the power to increase the minimum wage. Consumer goods companies are also known for making incremental wage increases for their workers. These minimum wage increases are a leading factor for wage push inflation. In consumer goods companies especially, wage push inflation is highly prevalent, and its effect is a function of the percentage increase in wages.
Industry Factors Driving Wage Inflation
Industry factors also play a part in driving wage increases. If a specific industry is growing rapidly, companies might raise wages to attract talent or provide higher compensation for their workers as an incentive to help business growth. All such factors have a wage push inflation effect on the goods and services the company provides.
Economists track wages closely because of their wage push inflation effects. Wage push inflation has an inflationary spiral effect that occurs when wages are increased and businesses must — to pay the higher wages — charge more for their products and/or services. Additionally, any wage increase that occurs will increase the money supply of consumers. With a higher money supply, consumers have more spending power, so the demand for goods increases. An increase in demand for goods then increases the price of goods in the broader market. Companies charge more for their goods to pay higher wages, and the higher wages also increase the price of goods in the broader market.
As the cost of goods and services rise at the companies paying higher wages and in the broader market overall, the wage increase is not as helpful to employees, since the cost of goods in the market has also risen. If prices remain increased, workers eventually require another wage increase to compensate for the cost of living increase. The percentage increase of the wages and prices and their overall effect on the market are key factors driving inflation in the economy.
An Example of Wage Inflation
If a state raises the minimum $5 to $20, that company must compensate by increasing the prices of its products on the market. But because the goods become more expensive, that raise isn't enough to propel a consumer's purchasing power, and the wage must be raised again, therefore causing an inflationary spiral.
Read more: Wage Push Inflation https://www.investopedia.com/terms/w/wage-push-inflation.asp#ixzz5QxwlVGHY
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Ref:
Wikipedia search "demand-pull inflation", available at
https://en.wikipedia.org/wiki/Demand-pull_inflation
[X] Own account.
b) Similar question was asked in
i) Monetary policy - The central bank can regulate the money policy by increasing in the money supply and reduce interest rates. A decrease in the discount rate, and a decrease in reserve requirements will make money supply more in the economy. This is expansionary monetary policy - an increase in the quantity of money in circulation, with corresponding reductions in interest rates, for the expressed purpose of stimulating the economy to generate growth.
Monetary policy can be undertaken by printing more paper currency. In modern economies, monetary policy is undertaken by controlling the money creation process performed through fractional-reserve banking.
The Federal Reserve System (or the Fed) is U.S. monetary authority responsible for monetary policy. In theory, it can control the fractional-banking money creation process and the money supply through open market operations (buying U.S. Treasury securities), a lower discount rate, and lower reserve requirements. In practice, the Fed primarily uses open market operations for this control.
An important side effect of expansionary monetary policy is control of interest rates. As the quantity of money increases, banks are willing to make loans at lower interest rates. Then, people with less motivation to keep money in the bank (as interest is low), will spend the money to create demand.
ii) Fiscal policy - Fiscal Policy refers to the regulation of the level of government spending, taxation and public debt. By tax cuts, rebates and increased government spending, this expansionary policies from central banks will increase the money supply in the economy. People with more money as tax is cut, and getting employment from government spending will consume more. This then spurs the domestic demand.
Fiscal policy is the use of government revenue collection (mainly taxes) and expenditure (spending) to influence the economy. According to Keynesian economics, when the government changes the levels of taxation and government spending, it influences aggregate demand and the level of economic activity. Fiscal policy is often used to stabilize the economy over the course of the business cycle.[1]
Changes in the level and composition of taxation and government spending can affect the following macroeconomic variables, amongst others:
- Aggregate demand and the level of economic activity;
- Saving and investment;
- Income distribution.
Fiscal policy can be distinguished from monetary policy, in that fiscal policy deals with taxation and government spending and is often administered by an executive under laws of a legislature, whereas monetary policy deals with the money supply and interest rates and is often administered by a central bank.
Ref:
Wikipedia search "fiscal policy", available at