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I'd like to start with a brief background on the Phillips curve. The Phillips curve presents a model of relationship between inflation and the level of aggregate activity - this aggregate activity is represented by the unemployment rate. There is an apparent inverse relationship between inflation and unemployment. I.e. there is a trade off between high inflation and low unemployment and between low inflation and high unemployment. The Phillips curve is named after the economist A.W. Phillips who observed such an empirical relationship in the 1950s.
There are two such sources of inflationary pressures and they are demand pull and cost push.
Firstly we will need to analyse demand pull inflation. Demand pull inflation is the effect of excess demand pressures in product and labour markets which generates increases in costs and hence prices. The rate of unemployment can be used to define these excess demand pressures. In the model we use the current rate of unemployment (u) and the unemployment rate defined as (un) at which there are no excess demand pressures. Un is considered to be "full employment output" i.e. unemployment is only structural and frictional. A graphical representation of the relationship between wage inflation (rate of change in wages) and unemployment can be used (figure 1.1) to show how excess demand pressures fuel inflation.
Since wage inflation is an important determinant in average costs of production, we can thus convert this excess demand and wage inflation relationship to a relationship between excess demand and inflation in the general level of prices. We assume that labour costs are the only cause for change in prices, that there is no productivity growth and that there are no other changes in other input costs.
Whenever the unemployment rate, such as u1, is below, the full employment point un we will have a situation of excess demand. If the level of aggregate demand expenditure were to increase from the full employment point, then the demand for labour to produce extra output would also increase. Since many of these labour markets are near or at full employment capacity, the increased or excess demand would simply push up wages. The lower (u) is pushed below un the greater the number of sectors that reach capacity. Higher investment, ouput, wages and growth employment results as frictionally unemployed people will be induced into the market by higher wages and better job opportunities. The greater these excess demand pressures the greater the rate of inflation.
P*=f (Un-U) + Cost push
However, demand pull inflationary pressures only looks at the effects of excess demand or the aggregate demand effects on inflation. We must also consider cost-push inflation which represents the effects of autonomous increases in costs (i.e. not caused by excess demands), such as wages (.e.g. the market power of unions), input costs or indirect taxes and inflationary expectations.
In figure 1.3, we assume some presence of initial cost push inflation at 3% at our full employment or non-accelerating inflation rate of unemployment. At (Un) p*=0. This may be a result of indirect taxes for example. Any subsequent cost-push inflation such as increases in autonomous factors e.g. monopoly power of unions or structural unemployment increases then the Phillips curve shifts upward.
But most importantly, inflationary expectations or inflationary psychology is the main cost-push factor.
Inflationary expectations (the most important cost-push factor) are important in understanding inflationary psychology. In figure 1.4, through the use of colours we can see the effect demand pull and cost push causes have on inflation, and the new inflationary expectations that arise with subsequent shifts in the PC.
Initially, At Un, workers are accustomed to 3% inflation and expect that inflation rate to prevail into the future. Thus the expectations of p*=3. If price levels changed, workers would demand an increase in their nominal wages to compensate for the loss of real purchasing power, and employers would similarly lift their product prices by the same rate. In this way inflation can become a self-fulfilling event as workers and employers act to protect their incomes.
Now suppose (in figure 1.4) the government believed the level of unemployment was too high and sought to reduce un with expansionary fiscal and monetary policy. Unemployment would fall from Un to U1, as the excess demand pulls up inflation - which leads to higher product prices. Higher product prices increase business profits and firms then respond by increasing ouput and hiring additional workers.
Now at point B1, we have demand pull inflation created by excess demand. But once workers that inflation is now 6% instead of 3% as it was previously, they will demand and receive nominal wage increases to restore the purchasing power they had lost. As businesses pass on these wage demands, business profits will fall back to their A1 levels. This profit reduction means that the original motivation of businesses to increase output and employ more people disappears. Unemployment results, and the PC shifts to A2, represented by PC (2). Unemployment has returned back to 6%, yet inflation is still 6% - as people had adjusted their expectations of inflation to 6%. P*e=6.
If the government tries to move unemployment back down to U1=4%, then the same process happens once more. The excess demand created by expansionary government policies will pull up product prices; induce higher business profits which will result in increased ouput and greater employment. But again, at B2, once workers realise inflation is actually 9% rather than 6% they will demand higher nominal wages to compensate for the loss of real purchasing power. Businesses will pass on the wage increases, but profits will be reduced, as such the motivation to increase ouput and hire more staff disappears. Unemployment results once more at the full employment point Un=6%, but with expectations of inflation adjusted once more - workers and employers expect 9% inflation (point A3).
Unemployment, as represented in figure 1.4 by our downward sloping Phillips curves - can deviate but only in the short term from the "full employment" output point. In the long run the economy returns to u=Un (i.e. the non accelerating inflation rate of unemployment). In the long run our Phillips curve is vertical as any stable (non accelerating) rate of inflation is consistent with the natural rate of unemployment.
In order to get inflation down, governments need to adopt contractionary policies. That is they will need to create such contractionary measures that u>Un. Policy needs to break inflationary expectations and inflationary psychology.
To conclude, demand pull as a cause of inflation is solely concerned with the excess demand (aggregate demand) that occurs when u<Un. While cost push inflation explains the effects of the aggregate supply side of the economy in determining inflation - i.e. autonomous price increases (e.g. wages) and also the important role that expectations can play in affecting inflation.