Demand pull inflation is caused by an initial increase in aggregate demand. Aggregate demand can increase due to a variety of factors. An interest rate cut can boost consumption; government generates demand by increased infrastructure projects or by cutting tax rates. Aggregate demand can also increase due to an increase in exports, or an increase in investment stimulated by an increase in expected future profits.

In a demand-pull inflation, initially

• Aggregate demand increases
• Real GDP increases above potential GDP and the price level rises. This leads to an inflationary gap.
• Money wages rates begin to rise.
• The price level rises further and real GDP decreases toward potential GDP.
• This process repeats in an unending price-wage spiral.

A one-time increase in aggregate demand raises the price level but does not always start a demand-pull inflation. For demand pull inflation to occur, aggregate demand must persistently increase. The money supply must persistently grow at a rate that exceeds the growth rate of potential GDP.

Cost push inflation is a result of an initial increase in costs. Increasing costs can be due to an increase in the cost of raw materials, e.g., oil, and an increase in the money wage rates. It can also increase due to a rise in prices of the raw material or products in the rest of the world.

In a cost-push inflation, initially:

• Short-run aggregate supply decreases
• Real GDP decreases below potential GDP and the price level rises (Stagflation)
• The economy could become stuck in this stagflation situation for some time.

The key difference between the two is that while GDP rises in demand-pull inflation it falls in Cost-push inflation in the initial phase.