Demand Pull Inflation

Demand-Pull Inflation Definition

Demand-Pull Inflation refers to inflation in the economy brought about by strong consumer demand wherein aggregate demand in the economy outweighs aggregate supply and hence the prices tend to go up. It is a phenomenon which is often described as too much money chasing too few goods. It is often a result of strong consumer demand. Many individuals when they purchase the same good, they will tend to make the prices rise, and usually when this happens to the whole of the economy usually for all the types of goods, and then such a situation is known as demand-pull inflation.

Demand-Pull Inflation Graph

The Demand-Pull Inflation can be shown through the below diagram as well:

Graph Demand Pull Inflation

Explanation of the above Demand-Pull Inflation graph is as follows-

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 and the Y-axis measures the General price level. The curve AS represents the aggregate supplyAggregate 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 which rises upward in the beginning but when a full-employment level of aggregate supply OYF is achieved, the supply curve of AS takes a vertical shape. This is because once full employment is achieved, a supply of output 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 the equilibrium is at less the complete employment level in which the price level of OP1 is arrived at. If the aggregate demand increases to AD2, the price level will rise to OP2 due to excessive demand at price OP1.

It’s also to be noted that the rise in 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 increase in output from OY2 to OYF. If aggregate demand increases to say AD4, only price level shall rise to OP4, with output remaining constant at YF. OYF is the full employment level/ output and the aggregate supply curve is perfectly inelastic at YF.

What Causes Demand-Pull Inflation?

The demand-pull inflation is caused by the following in an economy that can serve both as a cause and also as examples.

  • Consumption: An increase in consumption level pushes up the price of the certain product/commodity
  • Exchange Rate: Depreciation of home currency will boost exports and hence aggregate demand increases.
  • Government Spending: An increase in government spending will also boost up the aggregate demand in an economy.
  • Expectations: The very expectation of inflation will lead to a rise in inflation.
  • Monetary Growth: If there is too much money chasing too few goods inflation will rise.

Examples of Demand-Pull Inflation

Example #1 – US Housing Price Inflation in 2006

Credit Default Swaps CDS full form was a new type of insurance product that guaranteed against Defaults on mortgages and other types of loans. This coverage generated demand for another innovation in the form of ABS (Asset-based securities). These further allowed securities that monitored prices of mortgage to be sold in the secondary market like stocks and bonds.

Since all these involve complex calculations and assumptions, it led to the creation of 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 demand 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 inflation until 2006. Subsequently, supply caught up with demand and home prices started to fall spiraling the Global Financial crisis of 2008.

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

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

Another instance was the economic growth in the UK in the late 1980s. The below image shows the progress of economic growth 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 rates
  3. Reduction in the rates of Income-tax
  4. Increase in consumer confidence.

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 will 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 and this, in turn, boosts the economy
  • Benefit to borrowers – When there is inflation in the economy, it is the borrowers that tend to benefit from the same as the cash now is worth more than the cash in the future and as a result, the borrower will tend to repay the lenders with money worth less than what it originally was when they had borrowed it. Inflation will tend to reduce the real value of money and it is thus the borrower that tends to benefit from this, in the long run, owing to money which is being paid, being worthless
  • Increase in wages: – An increase in demand-pull inflation which causes the general rise in price levels will also make the companies put up wages. If companies do not go on to increase the wages of their staff it shall not be good for productivity and morale. Hence in times of increasing inflation employers do tend to increase wages of employees to help them match the increase in the standard of living brought about by inflation
  • Benefits lenders: – Suppose wages are not increased, 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 too stand to gain as they shall now be lending for the same good to a higher price and thereby collect more interest
  • 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 revenue. Moreover, the real value of government debt too shall now be eroded by inflation and the government will stand to benefit from this.

Disadvantages

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

  • Fall in 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 an increase in its price owing to demand-pull inflation. The value of the savings is further eroded if the rate of inflation is greater than the rate of return on such savings
  • Reduction in Standard of Living – Demand-pull inflation brings about an increase in the price of goods and commodities owing to higher demand. These goods and services will now be costlier to the common consumer and he/she may not be able to afford the product that they were using on a regular basis earlier. Hence inflation eats away the real power of money and hence consumers may be doomed to a lower standard of living
  • Disadvantage to Lenders – Owing to a decrease in the value of money due to inflation, the lender will be repaid an amount that is much lesser in value. The money received would be lesser in value and in its worth compared to what was lent originally due to a fall in the real value of money.

Limitation

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

Conclusion

Demand-pull inflation, as discussed, brings about a decrease in the value of money and erodes out 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, thereby reducing one to a lower standard of living and may be harmful to the economy. However, a certain range of inflation is good for the economy as it contributes to and boosts economic growth. It is for this reason that many countries adopt inflation targeting based policies to ensure inflation is channeled in the right manner to achieve the desired growth as required by the country.

This has been a guide to what is Demand-Pull Inflation and its definition. Here we discuss what causes Demand-Pull Inflation along with an example to understand this topic in a better manner. You may also take a look at some of the useful economics articles here:-

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