Macroeconomic Objectives & Policy
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What this topic is really about
Cost-push inflation is driven by rising production costs that shift the aggregate supply curve leftward, increasing prices.. Cost-push inflation arises when higher input costs, such as wages or imported raw materials, reduce short-run aggregate supply and push the price level up.
When there is significant spare capacity, the aggregate supply curve is relatively elastic, so higher aggregate demand mainly increases real output and employment rather than prices. Crowding out is limited in a deep slump where private investment is already weak.
See the mechanism
The marginal propensity to consume (MPC) determines how much of an injection is spent. Trace the diagram above to fix how the pieces of Macroeconomic Objectives & Policy fit together.
An exam-style question, fully explained
An economy's marginal propensity to consume is 0.75 and there are no other leakages besides saving. What is the value of the simple Keynesian multiplier?
- Identify what the question tests: An economy's marginal propensity to consume is 0.75 and there are no other leakages besides saving..
- The simple multiplier equals 1 divided by (1 minus the marginal propensity to consume), so it is 1 divided by 0.25.
- That gives a multiplier of 4, meaning an initial injection raises national income by four times its size.
- Why it matters: The marginal propensity to consume (MPC) determines how much of an injection is spent. An MPC of 0.75 means 75% of an injection is spent, so the remaining 25% is saved. To calculate the multiplier, we use the formula 1 / (1 - MPC), which gives 1 / 0.25 = 4.
Traps the examiner sets
- Students often forget to invert the formula or mistakenly include other leakages, such as taxes, in the calculation.
- Many students confuse cost-push and demand-pull inflation, thinking that they are interchangeable terms. However, cost-push inflation is specifically driven by supply-side factors, such as rising input costs, whereas demand-pull inflation is driven by demand-side factors, such as excess aggregate demand.
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