Demand-Pull Inflation

Updated on April 30, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Demand-Pull Inflation Definition

Demand-pull inflation refers to inflation in the economy brought about by strong consumer demand wherein aggregate demand outweighs aggregate supply. When the aggregate demand exceeds the overall supply, limiting the availability of the products, it tends to raise the prices of the available set of goods in the market.

Demand-Pull-Inflation

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While demand-pull inflation can be seen as bane for customers, they appear as a boon simultaneously, thereby leading to multiple employment opportunities. Similarly, when the employment rate increases, the demand for the products rise as individuals are capable of affording them.

Key Takeaways

  • Demand-pull inflation is the term used to describe economic inflation brought on by high consumer demand, where total demand exceeds total supply. As a result, prices usually go up.
  • Demand-pull inflation is caused due to consumption, exchange rate, government spending, expectations, and money growth.
  • The advantages of demand-pull inflation are that it boosts economic growth, benefits borrowers, increases wages, and benefits lenders and the government.
  • Demand-pull inflation has certain disadvantages, such as a fall in the money’s actual value, a reduction in the standard of living, and disadvantages to lenders due to the decrease in the money value. 

Demand-Pull Inflation Explained

Demand-pull inflation is one of the significant causes of inflation. In this scenario, the demand for products seems to pace up, while the supply of those items remains the same or decreases. As the supply is low, the prices of the products increase rapidly as the customer demand is on its peak and they are bound to buy the required items at any price.

The exceeding demand makes businesses have more people for producing more items to meet consumer demand. In ensuring that, they employ more and more people, thereby boosting the employment rate. At the same time, when the employment rate is high, more people are capable of buying products and services even if the price is high and the product is needed. This rising price of the products because of the increasing demand and submissive attitude of consumers to such raised prices cause inflation pulled by the demands. Hence, it is so named.

Demand-pull inflation, as discussed, brings about a decrease in the value of money and erodes the value of savings and investments if the rate of inflationRate Of InflationThe rate of inflation formula helps understand how much the price of goods and services in an economy has increased in a year. It is calculated by dividing the difference between two Consumer Price Indexes(CPI) by previous CPI and multiplying it by 100.read more is greater than the interests or amounts earned on such investments. Therefore, reducing one to a lower standard of living may harm the economy. On the other hand, however, a certain inflation range is good for the economy as it contributes to and boosts economic growth. For this reason, many countries adopt inflation targeting-based policies to ensure inflation is channeled in the right manner to achieve the desired change as required by the government.

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Causes

The demand-pull inflation is caused by an economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more that can serve as a cause and example.

Examples

Let us consider the following instances to understand the demand-pull inflation theory and its application even better:

Example #1 – US Housing Price Inflation in 2006

Credit default swaps CDS full form CDS Full FormA credit default swap is a financial transaction between a third party and a buyer. where the seller guarantees to compensate the buyer if the acquired asset defaults for any reason.read more was a new insurance product that guaranteed against defaults on mortgages and other loansLoansA loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment.read more. This coverage generated demand for another innovation in ABS (Asset-based securities) ABS (Asset-based Securities)Asset-backed Securities (ABS) is an umbrella term used to refer to a kind of security that derives its value from a pool of assets, such as bonds, home loans, car loans, or even credit card payments.read more. These further allowed securities that monitored mortgage prices to be sold in the secondary market Secondary MarketA secondary market is a platform where investors can easily buy or sell securities once issued by the original issuer, be it a bank, corporation, or government entity. Also referred to as an aftermarket, it allows investors to trade securities freely without interference from those who issue them.read more like stocks and bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more.

Since all these involve complex calculations and assumptions, it led to supercomputers that executed the processing. As demand for securities rose, so did the price of underlying assetsUnderlying AssetsUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more, which were houses. The need for banks for mortgages to underwrite the derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. read more was driving housing price inflationPrice InflationA Credit Default Swap (CDS) is a financial agreement between the CDS seller and buyer. The CDS seller agrees to compensate the buyer in case the payment defaults. In return, the CDS buyer makes periodic payments to the CDS seller till maturity.read more until 2006. Subsequently, supply caught up with demand, and home prices started to fall, spiraling debtDebtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.” url=”https://www.wallstreetmojo.com/financial-crisis/”]the Global Financial crisis[/wsm-tooltip] of 2008.

At the same time, the FED over-expands the money supply by lowering the Fed Funds rate to 1% to combat recession post the dot-com bubble. Though inflation did rise to around 3.3%, housing prices rose, further enhancing the drop.

Example #2 – Economic Growth & Inflation in the UK (1980 onwards)

Another instance was the economic growthEconomic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific period.read more in the UK in the late 1980s. The below image shows the progress of economic growth of over 4%:

uk economic growth 1980s

Source – Economicshelp.org

Inflation started to rise due to:

  1. The rise in housing prices.
  2. Cut in real interest ratesReal Interest RatesReal interest rates are interest rates calculated after taking inflation into account. It is a means of obtaining inflation-adjusted returns on various deposits, loans, and advances, and thus reflect the real cost of funds to the borrower. read more.
  3. Reduction in the rates of income tax.
  4. Increase in consumer confidence.

Graph

The concept is explained using a graph below. Let us have a look:

Graph Demand Pull Inflation

The X-axis measures the aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices.read more and supply. The Y-axis measures the general price level. The curve AS represents the aggregate supply Aggregate SupplyAggregate Supply is the projected supply that a business calculates based on the existing market conditions. Various factors such as changing economic trend are considered before calculating the aggregate supply.read more that rises upward initially. Still, when a full-employment level of aggregate supply OYF is achieved, the supply curve of AS takes a vertical shape. Once full employment is completed, output supply cannot be increased.

When the aggregate demand curveDemand CurveDemand Curve is a graphical representation of the relationship between the prices of goods and demand quantity and is usually inversely proportionate. That means higher the price, lower the demand. It determines the law of demand i.e. as the price increases, demand decreases keeping all other things equal.read more is AD1, equilibrium is less than the total employment level at which the price level of OP1 arrives. If the aggregate demand increases to AD2, the price level will rise to OP2 due to excessive demand at the price of OP1.

It is also to be noted that the rise in the price level has led to an increase in the output supplied from OY1 to OP2. If the demand further pushes to AD3, the price level also increases to OP3, under more demand pressure.

However, since the aggregate supply curveSupply CurveSupply curve represents the relationship between quantity and price of a product which the supplier is willing to supply at a given point of time. It is an upward sloping curve where the price of the product is represented along the y-axis and quantity on the x-axis.read more is still sloping upward, an increase in aggregate demand from AD2 to AD3 has utilized the rise in output from OY2 to OYF. If aggregate demand increases to AD4, only the price level shall rise to OP4, with the result constant at YF. OYF is the full employment level/ output, and the aggregate supply curve is perfectly inelastic at YF.

All about Inflation – Explained in Video

 
 

Effects

Demand-pull inflation, when occurs, impacts the market and the society in many ways. Though most of the effects appear to negative, it also has positive impacts that mark the development of the society. Let us have a look at the consequences of this type of inflation:

  • When the prices of even the basic products and services increase, the cost of living turns high.
  • With the increased cost of living decreases the purchasing power of the people due to their unaffordability.
  • Paying more for products becomes a major way of controlling further impact of inflation.
  • Cost of borrowing also witnesses a hike.
  • As the demand increases, the supply has to increase to stabilize the market. To achieve this, more people are employed, which thereby decreases the unemployment rate.

How To Control?

As demand-pull inflation can lead to negative effects on the society and the market, it becomes important to control it. To prevent this type of inflation, the government and higher authorities have to intervene with stricter fiscal policies. Some of the steps that the government might take to control the situation are as follows:

  • It may introduce a higher interest rate so that the customers control their spending habit. When they restrict their spendings, the product demand is controlled. The controlled demand helps businesses keep up with the supply, thereby restoring the demand-supply balance.
  • The government can also raise taxes and also restrict government spendings.

Advantages

There are certain advantages brought about by demand-pull inflation listed as under: –

  • Boosts economic growth – A fear in the minds of the consumers that inflation will keep rising the next year due to certain demands may make the consumer purchase the product this year rather than having to postpone the purchase decision. This act on the part of the consumers by purchasing the product right away would boost further economic growth as the buyer would now contribute to the income of the producer or the seller. That, in turn, increases the economy.
  • The benefit to borrowers – When there is inflation in the economy, the borrowers tend to benefit from the same as the cash now is worth more than the cash in the future. As a result, the borrower will manage to repay the lenders with money worth less than it originally was when they had borrowed it. In addition, inflation may tend to reduce the real value of money. Thus, the borrower tends to benefit from this, in the long run, owing to money that is being paid to be worthless.
  • Increase in wages – An increase in demand-pull inflation that causes the general rise in price levels may also make the companies pay more salaries. If companies do not increase the wages of their staff, it shall not be good for productivity and morale. Hence, in times of rising inflation, employers tend to increase employees’ salaries to help them match the increased standard of living brought about by inflation.
  • Benefits lenders – Suppose wages are not raised, the consumers will not have the additional money to purchase the goods now, owing to demand-pull inflation. Hence, they will resort to borrowing, and lenders also stand to gain as they shall now be lending for the same good at a higher price and thereby collect more interest.
  • The benefit to the government – As long as there is an increase in prices brought about by demand-pull inflation, the government also tends to enhance its tax revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more. Moreover, the real value of government debt will now be eroded by inflation, and the government will benefit from this.

Disadvantages

There are, however, certain disadvantages owing to demand-pull inflation, which are listed down as under: –

  • Fall in the real value of money – An increase in inflation erodes the real value of money as more money is required to purchase the same goods due to the rise in their price owing to demand-pull inflation. The value of the savings is further eroded if the inflation rate is greater than the rate of return on such reserves.
  • Reduction in the standard of living – Demand-pull inflation increases the price of goods and commodities due to higher demand. These goods and services will now be costlier to the common consumer. They may not be able to afford the product they were regularly using earlier. Hence, inflation eats away the real power of money, and therefore consumers may be doomed to a lower standard of living.
  • The disadvantage to lenders – Owing to a decrease in the value of money due to inflation, one will repay the lender an amount much lesser in value. Therefore, the money received would be more deficient in value and worth than what was lent originally due to a fall in the real value of money.

If a certain product has no demand, the price increase may not be attributed to demand-pull inflation. There may be other factors too that have come into play.

Demand-pull Inflation vs Cost-push Inflation

There are different factors that cause inflation. These are pull in demand, push in the cost and an expected inflation. While the later one is based on the expectation, the other two are prominently noticeable and hence, discussed more often.

The demand-pull inflation and cost-push inflation are similar to an extent, but they differ in the way they affect the system. Let us have a look at the differences between the two:

  • Demand-pull leads to inflation when the aggregate demand increases with the aggregate supply of goods and services remaining same or being decreased, thereby leading to higher costs. On the other hand, cost-push causes inflation as under this scenario, the demand remains the same, but the supply gets reduced due to multiple factors, including increased prices of products and services.
  • The causes of demand-pull inflation are real, and they arise out of the change in the monetary policies, while the cost-push inflation is caused by the misuse of monopolistic power, where the monopolies decide and increase the prices of the products.
  • The former can be prevented or controlled by the introduction of stricter fiscal policies. On the contrary, intervention of federal or state authorities with newer policies helps control cost-push inflation.

Frequently Asked Questions (FAQs)

 Is demand-pull inflation more common?

Yes, it is more commonly noticed in different parts of the world. This is normally because the factors that cause it are quite evident in all corners of the globe and hence, to remain out of the reach of increasing demands of the products and markets becomes inevitable.

Which scenario is an example of demand-pull inflation?

When the government invests money in scarce resources, demand-pull inflation may take place.

Is demand-pull inflation good?

The demand-pull inflation can be good in the short term, but it also requires a cautious observation.

Is demand-pull inflation worse than the cost-push inflation?

The demand-pull inflation reduces the consumer’s purchasing power, boosts spending to avert the more impact of inflation, and escalates the borrowing costs. Though the consequences are more negative, it is still considered a less problematic scenario, given the increase in the output that it facilitates. On the contrary, cost-push inflation affects the overall supply, thereby leading to either reduced production or wastage of already produced items.

This article has been a guide to Demand-Pull Inflation and its definition. We explain its causes, examples, vs cost-push inflation, graph, how to control it & effects. You may also take a look at some of the useful economics articles here: –

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