In the actual world, it is difficult to say precisely whether the rise in prices is due to demand-pull factors or cost-push factors. In fact inflation is a combination of both demand-pull and cost-push rise in prices; it may be termed as demand-cum-cost inflation.
The demand-pull inflation has the tendency to generate forces of cost-push inflation; when prices rise due to excess increase in aggregate demand, the workers demand higher wages in view of a rise in cost of living.
Similarly, the cost-push inflation generates demand-pull elements of inflation; when wages are pushed up, the workers’ monetary demand for consumption goods increases due to their higher incomes.
Thus, it is wrong to dichotomies the inflationary process into demand-pull and cost-push rise in prices. As H. G. Johnson has remarked.
“The two theories are, therefore, not independent and self-contained theories of inflation but rather theories concerning the mechanism of inflation in a monetary environment that permits it.”
The actual working of the inflationary process is like this: If aggregate demand increases with given output, the prices will rise. As a result, the cost of living will rise and the workers will demand higher wages.
When they succeed in it, their incomes will go up and thus aggregate demand will increase. But, on the other hand, higher costs due to rise in wages will push up the prices. Thus, inflation means demand-cost-price spiral.
The combined demand-cum-cost inflation is illustrated in Figure 6. SS and DD are the original aggregate supply and demand curves respectively. They intersect each other at point E, indicating the full employment output level OM.
The initial price is OP. When aggregate demand increases from DD to D1D1 it intersects the SS supply curve at point E, and the price level rises from OP to OP1. The increase in price level will force the trade unions to secure higher wages for the workers.
This will raise the cost of production. As a result, a higher aggregate supply curve S1S will intersect D1D curve at point A, showing a reduction in employment (from OM to OM1) and a rise in price level (from OP2 to OP2).
In order to achieve full employment, the aggregate demand must increase to D2D2. It means that full employment is achieved only at a higher price level OP3.
(a) Demand-pull inflation and cost-push inflation move together and lead to cumulative rise in prices.
(b) The forces behind demand-pull inflation are increases in money supply and aggregate expenditure, while the causes of cost-push inflation are mainly rise in wages, profits and material costs,
(c) Of the two types of inflation, cost- push inflation is much more difficult to control than demand-pull inflation. Demand-pull inflation can be controlled by adopting proper monetary and fiscal measures.
But, it is not easy to reduce cost of production through such measures; a reduction in wage rate, for example, will be strongly opposed by the workers.