Learn about the differences between demand inflation and cost inflation.
The distinction between a demand inflation and a cost inflation is purely theoretical. It is difficult to make this distinction in practice. The wage-price spiral is a normal feature of both types of inflation. In the case of demand inflation, the rise in the price level leads to the rise in the wage rate. In the case of a cost inflation, the rise in the wage rate leads to a rise in the price level.
If we can identity what had risen first, we could then say whether it was a demand inflation or a cost inflation. In practice, both prices and wages are unstable over time. This instability can be created either from the demand side or from the cost side.
These changes are indicated by the respective index numbers which fail to indicate what has led to what, because the time gap between a price rise and a wage rise is much shorter than a year, whereas the index numbers calculation is limited to annual data. The arbitrary choice of a base period makes a conclusion quite misleading.
It has been suggested that we should see which of the two — the price level or money wage rate — has increased more. If the rise in the price level is greater than the rise in the money wage rate, we can say that it is a case of a demand inflation. In the opposite case, we can say it is a case of cost inflation.
Again, it may be argued that the price rise caused by an increase in the aggregate demand leads to a rise in profit and profit rate, until the wage rate is raised by the increased demand for labour. Thus, when the rise in the price level is associated with increase in profit rates and with wage rates lagging behind, we can say that it is the case of a demand inflation. Both the comparisons between the price level and the wage rate and between the wage rate and the profit rate are elusive because of the arbitrary selection of base period.
It may further be argued that if increases in the wage rate are caused by rises in labour productivity, it would not be a cause of inflation. Thus, when the rise in the wage rate exceeds the rise in labour productivity it may be regarded as the case of a cost inflation.
However, a demand inflation does not leave the wage rate unchanged; the rise in the wage rate produced by the increase in demand for labour may be so high that it exceeds the rise in labour productivity. Thus, the comparison between the rises in the labour productivity and the wage rate is inconclusive with regard to the distinction between a demand and a cost inflation.
The theoretical models of the two types of inflation developed here suggests a method of distinction which should be examined in detail. There is an excess demand for labour in the case of a demand inflation and, thus, we can expect that a demand inflation should be associated with a condition of full employment in the economy or at least a falling unemployment. Whereas, a cost inflation should be associated with a rise in the level of unemployment.
Thus, we need to examine the percentage of labour force unemployed to make a distinction between a demand inflation and a cost inflation. A rising percentage of unemployment indicates a cost inflation, whereas a falling percentage indicates a demand inflation. But this theoretically conclusive test for the distinction fails in practice because of a number of other considerations.
First, most of the governments in the developed economies are committed to the policy of maintaining full employment with the help of suitable fiscal and monetary measures. When a cost inflation threatens to aggravate the employment situation, the expansionary policy of the government counteracts the effects of the cost inflation. Thus, we may not find rise in the percentage of unemployment even at the time of cost inflation.
Second, the theory of cost inflation rests on the hypothesis that the trade unions have powers of raising the wage rate. This hypothesis has been tested and it has been found that there is a positive correlation between the strength of the trade unions and the level of economic activity.
The level of economic activity varies inversely with the percentage of unemployment. Trade unions are generally more active at the time of rising level of economic activity. They are also successful in realising their demand at that time. Thus, we find that falling unemployment is associated with rising wage rates.
The “Phillips Curve” gives a relationship between unemployment and the rate of change of money wage rates in the U.K., between 1861-1957, which shows that, the rate of change of money wage rates would be high when unemployment is low and low or negative when unemployment is high. In view of the difficulties mentioned above, the distinction between a cost and demand inflation becomes unworkable. The “Phillips Curve” has been discussed in details above.