A great part of the post-Keynesian/monetarist debate arose from disagreement about the causal routes of inflation. In this respect, the question of whether it is possible to implement a test which will distinguish between cost-push and demand-pull inflation has a direct relevance to the selection of policies designed to avoid inflation. The extreme cost-push position advocates that only institutional factors are responsible for causing inflation; therefore, an institutional reform through, for example, prices and incomes polices is called for. Demand-pull adherents propose that long-run solutions to inflation must be based on demand restraint policies. Here, both the monetarist model and the Keynesian inflationary gap model are in agreement. Monetarists, however, claim that "inflation is always and everywhere a monetary phenomenon"(1) and, as such, prefer a regime of monetary control in which the growth rates of money and nominal income are compatible. In other words, monetarists contend that money supply |causes' prices without feedback. By contrast, neo-Keynesians hold that through the inflationary gap, changes in real income (aggregate demand) are expected to cause changes in prices. The endogeneity of income and prices in a simultaneous Keynesian system also implies that income and prices exhibit bidirectional causality.
Conventionally inflation was mainly explained through the wage/price (Phillips curve) approach which has been claimed to explain both demand-pull and cost-push inflation. Samuelson and Solow (1960) argued that if costs and prices are insignificantly sensitive to demand-restraint policies such that unemployment significantly increases, then cost-push inflation is dominant; and likewise the reverse is true for demand-pull inflation. Up to the 1970's markup models dominated inflation theory, but since that time monetarist models have taken over. Gordon (1988) argued that inflation (changes in the GNP deflator) do not statistically explain the behavior of each other; indicating that markup pricing hypothesis is dead. Notwithstanding, one of the by-products of this paper is to signify that such conclusions are probably sensitive to the type of price index used. Furthermore, reduced-form regressions are more indicative of correlation relationships than causal linkages. Of course, a bidirectional causality between wages and prices is supportive of cost-push theory in which case firms are bound to adjust any price expectation by the average costs, indicating that markup pricing may still be alive.
Numerous other studies by, for example, Cushing and McGarvey (1990), Gutherie (1981), Silver and Wallace (1980), and Engle (1978), among others, have examined the causal linkages between the CPI and the producer price index (PPI). Using one-way distributed lags, Gutherie, Silver and Wallace, and Engle found a unidirectional causality going from wholesale prices to consumer prices, a result which is consistent with markup pricing (cost-push) theory. Cushing and McGarvey are supportive of the perfectly flexible price (derived demand) and strong demand elements theory. However, it should be pointed out that using one-way causality testing from producer prices to the CPI to support markup pricing implies a fixed wage rate postulation (as in traditional Keynesian models). Likewise, the perfect (foresight) flexible prices (or the full-employment model) assumes away money illusion...