Command term: Illustrate

Key terms to define: Cost push deflation, demand pull deflation

The command term illustrate means use diagram (s) to explain the difference between the two concepts.

Cost push deflation is sometimes called good deflation and is illustrated on diagram 1 by a right shift in the AS curve, leading to lower average prices (PL1 to PL2) as well as higher real output levels (Y1 to Y2).  On the diagram the rise in LRAS results in a fall in average production costs, meaning that producers are more willing and able to produce goods and services at the same price.  Examples of factors that can lead to cost-push deflation include a rise in currency value, making imported goods cheaper; a fall in oil prices; or an improvement in productivity resulting from technological advancement.

Demand-pull deflation is often called bad deflation and would be illustrated by a fall (or left shift) in the AD curve, leading to an output or deflationary gap. 

Demand pull deflation, like cost push deflation reduces average price levels in the economy but does at the expense of real GDP, illustrated on diagram 2 by a fall in average price level from PL1 to PL2 and a decrease in real GDP from Y1 to Y2.

Examples of factors that may cause a fall in aggregate demand include:

• a rise in interest rates / contractionary monetary policy
• a fall in government spending or a rise in tax rates
• external factors such as a global or regional slow down in economic activity.

Command term: Evaluation

Key terms: Cost push inflation, demand pull inflation

In this example the command term evaluate means weighing up the strengths and weaknesses of the statement and reach a conclusion supported by evidence.

Real life examples might include nations that have successfully maintained a low rate of inflation over a period of time e.g. the role of the European central bank in maintaining a low rate of interest throughout the Eurozone.

Supply side (cost push) inflation is caused by rising production costs in the economy and can only effectively be brought under control by the implementation of supply side policies.  This is illustrated by the first diagram, where a government has successfully managed to reduce production costs, using supply side policies and average price levels have fallen from PL1 to PL2.  Note that this is a fall in the rate of average price rises (disinflation) and not deflation which represents an economy with falling prices or an inflation rate below zero.

Examples of supply side measures that might be effective include:

• increasing the productivity of labour by investing in skills and training (making labour more productive)
• investing in improved technology (making capital more efficient)
• investment in infrastructure so that goods and services can be transported more easily (making land more efficient).

However the above are long term measures, taking years to take effect.  In the short run AS can be increased by the following range of measures:

• increasing the value of the currency so that imports are cheaper to purchase
• reducing interest rates so that firms can borrow more at lower rates (increasing capital)
• domestic subsidies.

In terms of demand pull inflation, governments can reduce inflationary pressure by reducing aggregate demand levels in the economy.  This can be achieved by a combination of contractionary fiscal and monetary policies.  This is illustrated on diagram 2 by a fall in aggregate demand from AD1 to AD2.

Fiscal policies might include raising taxes and / or reducing government spending levels.  Of course such a policy is difficult for any government to implement.  Raising taxes is very unpopular politically and simply reducing public spending levels will also have an impact on a number of people in the electorate.  Those voters are likely to take out their disappointment at any cuts to government services during their next opportunity to vote.

Monetary policies,therefore, are the most widely used measure and governments can reduce inflationary pressures in the economy by reducing the money supply and / or increasing interest rates.  Though it is important to note that a number of governments no longer directly control monetary policy, with control of the money supply and interest rates instead under the control of an independent Central bank.

From a monetarist perspective a government wishing to keep inflationary pressures in check must ensure that growth in the money supply rises no quicker than the rate of economic growth in the economy.

Real life examples might include nations that have successfully maintained a low rate of inflation over a period of time e.g. EU, USA and the UK.  For example, a response might discuss the role of the European central bank in maintaining a low rate of interest throughout the Eurozone.

A suitable conclusion would note that the appropriate course of action would depend on the type of inflation and must also consider the impact on other macroeconomic indicators.