- Demand Pull Inflation | Example And Causes of Demand Pull Inflation
- Causes of Demand Pull Inflation
- Countering Demand Pull inflation
- Recommended Articles
- Difference Between Demand-Pull and Cost-Push Inflation (with Comparison Chart)
- Content: Demand-Pull Inflation Vs Cost-Push Inflation
- Comparison Chart
- Definition of Demand-Pull Inflation
- Definition of Cost-Push Inflation
- Demand-pull inflation
- Demand-pull inflation means:
- How demand-pull inflation occurs
- Economic growth and long-run trend rate
- Causes of demand-pull inflation
- Demand pull inflation and Phillips Curve
- Examples of demand pull inflation
- Demand pull inflation and other types of inflation
- Decline of demand pull inflation
- Demand Pull Inflation (Definition, Example) | Demand Pull Inflation Causes
- Demand-Pull Inflation Graph
- What Causes Demand-Pull Inflation?
- Example #1 – US Housing Price Inflation in 2006
- Example #2 – Economic Growth & Inflation in UK (1980 onwards)
- Demand Pull Inflation
- 2. Exchange Rate
- 3. Government Spending
- 4. Expectations
- 5. Monetary Growth
- Demand Pull Inflation Example
- The Result
- Countering Demand Pull Inflation
- What Is Demand-Pull Inflation and What Causes It?
- What Is Demand-Pull Inflation?
- 1. Economic Growth
- 2. Surge in Exports
- 4. Inflation Forecasts
- 5. Exorbitant Supply of Money
- Demand-Pull Inflation Vs. Cost-Push Inflation
- Demand-Pull and Cost-Push Inflation
- Demand-Pull Inflation
- Cost-Push Inflation
Demand Pull Inflation | Example And Causes of Demand Pull Inflation
Demand pull inflation is the phenomenon when prices increase in the economy because of an increase in demand. In economic terms, it is quite popularly quoted as “too much money chasing too few goods”.
It usually starts with an increased demand which forces suppliers to increase the production but since increasing supply takes some time, there arises a scenario when there are too many buyers for the same number of goods leading to misbalance in the price equilibrium.
Suppliers react to such a scenario by increasing the prices and in turn shifting to a new equilibrium in the demand-supply curve.
Consider a simple example of an economy which is growing at a decent rate of 3% and the inflation growth is maintained at 2%. Now the government decided to increase the growth rate to attract more investments from foreign as well as local investors.
The government decides to expand its monetary policy by reducing the interest rates (repo rate) making credit cheaper for common people. Henceforth Banks are ready to give more credit at reduced rates making it easier to take home loans, auto loans or credit cards leading to increasing expenditure and eventually demand. This will lead to an increased growth rate of 5%.
However, this growth rate has a price – inflation as because of the increased number of buyers the inflation will also increase to 4%.
Causes of Demand Pull Inflation
There are mainly five Demand Pull Inflation causes. Let’s go through them one by one:
A growing economy fills everyone with optimism. Companies are hopeful that their products will find buyers, employees are optimistic that they will get good hikes, graduates are optimistic they will get good high paying jobs.
Everyone feels that the economy is on track and the government is doing its best in managing it. In such a scenario people spend more, take loans, buy cars and houses.
This increases demand and is one of the most common and healthy causes of demand pull inflation.
This economic situation corresponds to the scenario when people expect inflation in the near future and hence buy things now to avoid buying at higher prices later. Howsoever funny it may sound; this anticipation of inflation creates a Demand Pull and in turn, leads to inflated prices.
The United States faced this problem in the early 70s when firms didn’t reduce prices in anticipation of higher prices and president Nixon imposed wage hike controls which reduced spending by common people impacting economic growth. This economic situation was termed as stagflation.
Government spending can also lead to Demand pull inflation. Let’s say the government plans to start some infrastructure projects the expansion of metro lines or building new highways. Such a scenario attracts investments not only from the local businessmen but also from international investors.
For local businessmen, this is an opportunity to invest in a new business or to expand their existing business. For international investors, this is an opportunity to maximize return on their investments compared to their home country. Both these factors result in more money coming to the economy which leads to high prices.
For example, say the government decides to expand the highway network to a nearby area which improves its connectivity to the state capital reducing traveling time from 2 hrs. to 1 hr. This will attract investments from both foreign and local businessmen to buy land there (which will still be less than state capital) and build their offices.
Better connectivity will reduce the problem of talent, transporting raw materials and finished goods. All these factors will eventually lead to an increase in the land prices in that area.
A devaluation in the exchange rate of the local currency affects the economy as it leads to expensive imports and reduced prices of exports.
Hence, consumers will be more inclined to buy local products and would avoid imported products thereby benefitting local industries. The improved demand will increase the prices of locally made products leading to a new equilibrium.
China has been criticized to follow this policy and benefiting its home industries by intentionally undervaluing its currency.
Sometimes the government feels that the economy is not growing on expected lines. In that case, the central bank will take measures to increase the money supply in the economy. With more money at their disposal, people will to spend more which will increase demand.
For example, a central bank can reduce the repo rate which decreases the rate of interest on home loans and auto loans.
This will attract consumers as they are getting the same money at cheaper rates and will start buying more leading to more demand and hence increase in prices.
Marketing can also create high demand for products. As explained by great marketing professors, consumers sometimes themselves are not aware of their needs. Marketing helps in bridging that gap leading to increased demand. A great example would be Apple and Xiomi firms where the demand for their products increased because of innovative marketing techniques.
In fact, their marketing not only increased the number of consumers but also created a loyal customer base which makes cross-selling easier. People now believe that these brands understand their needs so well that they can blindly buy their products.
Similarly, a company Google which has technically advanced products can demand premium pricing as long as there is no other competitor.
Countering Demand Pull inflation
If not countered at the right time, demand pulls inflation can be very detrimental to the economy. Consider the example of Zimbabwe and Venezuela where inflation has transformed into hyperinflation leading to a catastrophic chain of events and eventually a civil war.
Learning from these examples governments and central banks should try to address the root causes rather than taking a short cut route. They can increase interest rates, decrease government spending or increase taxes.
Increasing interest rates in a phased manner are one of the best, time tested and simplest solutions as it not only decreases consumer expenditure but also incentivizes investments taking away extra money from the economy.
Here a balance must be maintained as this will affect growth and that is why the central bank must take a holistic view of the economy before taking any decision.
This has been a guide to Demand Pull Inflation. Here we discussed the example and different causes of Demand Pull Inflation. You may also take a look at some of the useful articles here to learn more:-
Difference Between Demand-Pull and Cost-Push Inflation (with Comparison Chart)
Inflation refers to the rate at which the overall prices of goods and services rises resulting in the decrease in the purchasing power of the common man, which can be measured through Consumer Price Index.
Modern analysis of inflation revealed that it is mainly caused either by demand side or supply side or both the factors.
Demand side factors result in demand-pull inflation while supply side factors lead to cost-push inflation.
The demand-pull inflation is when the aggregate demand is more than the aggregate supply in an economy, whereas cost push inflation is when the aggregate demand is same and the fall in aggregate supply due to external factors will result in increased price level. This article explains clearly the significant difference between demand-pull and cost-push inflation.
Content: Demand-Pull Inflation Vs Cost-Push Inflation
- Comparison Chart
- Key Differences
|Meaning||When the aggregate demand increases at a faster rate than aggregate supply, it is known as demand-pull inflation.||When there is an increase in the price of inputs, resulting in decrease in the supply of outputs, is is known as cost-push inflation.|
|Represents||How price inflation begins?||Why inflation is so difficult to stop, once started?|
|Caused by||Monetary and real factors.||Monopolistic groups of the society.|
|Policy recommendations||Monetary and fiscal measures||Administrative control on price rise and income policy.|
Definition of Demand-Pull Inflation
Demand Pull Inflation arises when the aggregate demand goes up rapidly than the aggregate supply in an economy. In simple terms, it is a type of inflation which occurs when aggregate demand for products and services outruns aggregate supply due to monetary factors and/or real factors.
- Demand-Pull Inflation due to monetary factors: One of the major cause of inflation is; increase in money supply than the increase in the level of output. The German inflation, in the year 1922-23 is the example of Demand-Pull Inflation caused by monetary expansion.
- Demand-Pull Inflation due to real factors: When the inflation is due to any one or more of the following reasons, it is said to be caused by real factors:
- The increase in government spending without the change in tax revenue.
- Fall in tax rates, with no change in government spending
- Increase in investments
- Decrease in savings
- Increase in exports
- Decrease in imports
these six factors, the first four factors, will result in the rise in the level of disposable income. The increase in aggregate income result in the increase in aggregate demand for goods and services, causing demand-pull inflation.
Definition of Cost-Push Inflation
Cost push inflation means the increase in the general price level caused by the rise in prices of the factors of production, due to the shortage of inputs i.e. labour, raw material, capital, etc. It results in the decrease in the supply of outputs which mainly use these inputs. So, the rise in prices of the goods emerges from the supply side.
Moreover, cost-push inflation may also be caused by depletion of natural resources, monopoly and so on. There are three kinds of cost-push inflation:
- Wage-push inflation: When the monopolistic groups of the society labour union exercise their monopoly power, to enhance their money wages above the competitive level, which cause an increase in the cost of production.
- Profit-push inflation: When the monopoly power is used by the firms operating in the monopolistic and oligopolistic market to increase their profit margin, leading to rise in the price of goods and services.
- Supply shock inflation: A type of inflation arising due to unexpected fall in the supply of necessary consumer goods or major industrial inputs.
The differences between dDemand-pull and cost-push inflation can be drawn clearly on the following grounds:
- Demand-pull inflation arises when the aggregate demand increases at a faster rate than aggregate supply. Cost-Push Inflation is a result of an increase in the price of inputs due to the shortage of cost of production, leading to decrease in the supply of outputs.
- Demand-pull inflation describes, how price inflation begins? On the other hand, cost-push inflation explains Why inflation is so difficult to stop, once started?
- The reason for demand-pull inflation is the increase in money supply, government spending and foreign exchange rates. Conversely, cost-push inflation is mainly caused by the monopolistic groups of the society.
- The policy recommendation on demand-pull inflation is associated with the monetary and fiscal measure which amounts to the high level of unemployment. Un, cost push inflation, where policy recommendation is related to administrative control on price rise and income policy, whose objective is to control inflation without increasing unemployment.
Therefore, you can conclude with the above discussion the main reason for causing inflation in the economy is either by demand-pull or cost-push factors.
It is often argued that which is the supreme factor for inflation, which one of the two-factor causes rise in the general price level for the first time.
Experts hold that demand-pull factor the leading factor for inflation in any economy.
Demand-pull inflation is a period of inflation which arises from rapid growth in aggregate demand. It occurs when economic growth is too fast.
If aggregate demand (AD) rises faster than productive capacity (LRAS), then firms will respond by putting up prices, creating inflation.
- Inflation – a sustained increase in the price level.
- Demand-pull inflation – inflation caused by AD increasing faster than AS.
Demand-pull inflation means:
- Excess demand and ‘too much money chasing too few goods.’
- The economy is at (or ver close to) full employment/full capacity.
- The economy will be growing at a rate faster than the long-run trend rate.
- A falling unemployment rate.
How demand-pull inflation occurs
If aggregate demand is rising at 4%, but productive capacity is only rising at 2.5%; firms will see demand outstripping supply. Therefore, they respond by increasing prices.
Also, as firms produce more, they employ more workers, creating a rise in employment and fall in unemployment. This increased demand for workers puts upward pressure on wages, leading to wage-push inflation. Higher wages increase the disposable income of workers leading to a rise in consumer spending.
Economic growth and long-run trend rate
The long trend rate of economic is the sustainable rate of economic growth; it is the rate of economic without any demand-pull inflation. If economic growth exceeds this long-run trend rate, then it will cause inflationary pressures.
In a boom, growth is above the long-run trend rate, and it is in this situation where we will get demand-pull inflation.
Causes of demand-pull inflation
- Lower interest rates. A cut in interest rates causes a rise in consumer spending and higher investment. This boost to demand causes a rise in AD and inflationary pressures.
- The rise in house prices. Rising house prices create a positive wealth effect and boost consumer spending. This leads to a rise in economic growth.
- Rising real wages. For example, unions bargaining for higher wage rates.
- Devaluation. Devaluation in the exchange rate increases domestic demand (exports cheaper, imports more expensive). Devaluation will also cause cost-push inflation (imports more expensive)
Demand pull inflation and Phillips Curve
Demand-pull inflation can also be shown on a Phillips Curve. A rise in demand causes a fall in unemployment (from 6% to 3%) but an increase in inflation from inflation of 2% to 5%.
Examples of demand pull inflation
From 1986, inflation increased to 1991. This was an example of demand-pull inflation.
The inflation of the late 1970s was due primarily to cost-push factors (wages/oil prices of 1970s)
The quarterly growth rate in the UK.
During the late 1980s, the rate of economic growth in the UK rose to over 4%. The high rate of economic growth was caused by demand-side factors, such as:
- Rising house prices
- Cut in real interest rates
- Cut in income tax rates.
- Rise in consumer confidence
The rapid growth in demand saw inflationary pressures increase.
US late 1960s
US Inflation: St Louis Fed
Rapid economic growth in the mid-1960s, caused inflation to increase from 2% in 1966 to 6% by 1970.
Demand pull inflation and other types of inflation
Demand pull inflation could occur with:
- Cost-push inflation (rising costs of production). For example, in the early 1970s, economic growth and rising oil prices caused a spike in US inflation of 12% by 1974.
- Built-in inflation. Inflation has its own momentum. High inflation in previous years, makes future inflation more ly as firms put up prices in anticipation of repeated inflation.
Decline of demand pull inflation
Source: World Bank
In recent years, demand-pull inflation has become quite rare. The small rises in inflation (2008/2001) were primarily due to cost-push factors. In recent decades, we have not witnessed any significant demand-pull inflation. this is due to several factors
- Independent Central Banks responsible for monetary policy and keeping inflation to a target of 2%
- Secular stagnation. Lower rates of economic growth
- Downward pressure on prices from the global economy. Deflation of manufactured goods in Asia.
- New technology leading to lower prices.
- See also: fall in global inflation
- Causes of inflation
- Boom and bust economic cycles
Demand Pull Inflation (Definition, Example) | Demand Pull Inflation Causes
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:
Explanation of the above Demand-Pull Inflation graph is as follows-
The X-axis measures the aggregate demand and supply and the Y-axis measures the General price level. The curve AS represents the aggregate supply 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 curve 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.
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However, since the aggregate supply curve 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
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 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 assets which were houses.
The demand for Banks for mortgages to underwrite the derivatives 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%:
Source – Economicshelp.org
Inflation started to rise due to:
- The rise in housing prices
- Cut in real interest rates
- Reduction in the rates of Income-tax
- Increase in consumer confidence.
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.
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.
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.
Demand Pull Inflation
In an Aggregate Demand and Aggregate Supply diagram, an increase in the aggregate demand curve leads to an increase in the rate of inflation, i.e., when the aggregate demand for goods and services is greater than the aggregate supply. Demand Pull Inflation is defined as an increase in the rate of inflation caused by the Aggregate Demand curve. It is the most common cause of inflation.
Demand Pull Inflation involves inflation rising as real Gross Domestic Product rises and unemployment falls, as the economy moves along the Phillips Curve. Demand Pull Inflation is commonly described as “too much money chasing too few goods”.
More accurately, it should be described as involving “too much money spent chasing too few goods,” since only money that is spent on goods and services can cause inflation. This rise in price level is not expected to happen unless the economy is already at a full-employment level. The term demand-pull inflation is mostly associated with Keynesian economics.
For example, if aggregate demand is rising at 3%, but the productive capacity is only rising at 2%. Thus, firms will see that demand is outstripping supply and will respond by increasing prices. As firms produce more, they will hire more workers.
This hiring spree will cause a fall in unemployment. This increased demand for workers puts upward pressure on wages, leading to wage-push inflation.
Finally, higher wages increase the disposable income of employees, leading to a rise in consumer spending.
Demand Pull Inflation Graph
The effect of inflation will depend on how steep the Aggregate Supply curve is, as in how close it is to full employment. The closer it is, the higher the rise in inflation. This effect can be seen more clearly in the Keynesian Aggregate Demand curve.
If there is a sharp increase in consumption and investment along with extremely positive businesses atmosphere, then there will be a rise in Aggregate Demand.
2. Exchange Rate
A depreciation of the exchange rate increases the price of imports and reduces the price of a country’s exports. Consumers will buy fewer imports, while exports grow. There will be an increase in Aggregate Demand.
3. Government Spending
An enormous increase in government spending will drive up Aggregate Demand.
The expectation that inflation will rise often leads to a rise in inflation. Workers and firms will raise their prices to ‘catch up’ to inflation.
5. Monetary Growth
If there is excessive monetary growth – when they are too much money in the system chasing too few goods. The ‘price’ of a goodwill thus increase.
Demand Pull Inflation Example
We can take an example of a small country named Staples with a landmass of just 100 square miles. Despite its historically impressive growth rate, Staples now faces an aging workforce and declining infrastructure. A few years ago, the inflation rate was 3%. However, the data now suggest that the country is falling behind on its growth target.
The central bank of Staples is eager to maintain the growth rate. The central banks decide to enact an aggressive expansionary monetary policy.
It decreased the discount rate to push interest rates down, purchased government bonds, decreased required reserve ratios, and let the commercial banks loosen credit standards. These policies resulted in a massive increase in consumption.
The country’s demand for cars and refrigerators increased to 5,000 vehicles per month and 3,000 refrigerators per quarter, respectively. However, the country could only produce 2,000 cars per month and 1,500 refrigerators per quarter.
Staples is now experiencing Demand Pull inflation. The decline in growth rate was due to an aging population and decaying infrastructure. The problem could only be solved by improving the skills of the workforce and by investing in the infrastructure. By employing an expansionary monetary policy, the excess money increased demand, without increasing the capacity.
Countering Demand Pull Inflation
To counter demand pull inflation, governments, and central banks would have to implement a tight monetary and fiscal policy. Examples include increasing the interest rate or lowering government spending or raising taxes.
An increase in the interest rate would make consumers spend less on durable goods and housing. It would also increase investment spending by firms and businesses.
In demand pull inflation, Aggregate Demand D is rising too fast, so these contractionary policies would lower the rise, meaning inflation would still occur but at a lower rate.
In the diagram above, with a tight monetary and fiscal policy, Aggregate Demand shifts from AD1 to AD*, instead of AD2 (a higher rate of inflation). This leads to an equilibrium price level of P* and output Y*, instead of P2 and Y2.
Member since 20 June, 2011
Prateek Agarwal’s passion for economics began during his undergrad career at USC, where he studied economics and business. He started Intelligent Economist in 2011 as a way of teaching current and fellow students about the intricacies of the subject. Since then he has researched the field extensively and has published over 200 articles.
What Is Demand-Pull Inflation and What Causes It?
The concept of demand-pull inflation has been around since it was first conceptualized in the 1930s. As old as the idea is, demand-pull inflation is still very much relevant today. Find out what drives this type of inflation and how it can impact modern economies.
What Is Demand-Pull Inflation?
Demand-pull inflation is a type of
that is influenced by growing demand for a good or service. When the aggregate demand — or the total demand in a market — is higher than the aggregate supply — or the total supply in a market — prices will rise. It is commonly described as «too much money chasing too few goods.»
Demand-pull inflation is a specific phenomenon, and it typically refers to an effect not just impacting individual goods and services or markets, but entire economies.
This concept was originally developed as part of Keynesian economics, a set of economic theories developed by John Maynard Keynes during the early half of the 20th century. Much of his economic ideas set out to understand the Great Depression and were built around the goal of encouraging peak economic performance by influencing consumer demand for goods and services.
1. Economic Growth
When an economy is thriving, people and businesses tend to feel more confident in spending their money.
They are secure in the idea that they will continue to be employed or even have a higher salary in the future, meaning that they are less inclined to save and more ly to borrow money.
When this happens, general demand rises and many businesses may have trouble keeping pace with the increased demand.
2. Surge in Exports
Exchange rate depreciation can drive aggregate demand and create demand-pull inflation by encouraging a high level of exports. Typically when this happens people in a country buy fewer imports while at the same time exports from their country increase.
4. Inflation Forecasts
When economists, the government, or major media outlets forecast inflation, this can unintentionally cause demand-pull inflation through a couple of avenues.
First, some companies may raise their prices preemptively to meet the expected inflation. Second, some consumers may make major purchases preemptively to avoid paying higher prices later.
This can create greater demand and result in demand-pull inflation.
5. Exorbitant Supply of Money
All governments must occasionally create more currency, but when a government prints too much money, this can create demand-pull inflation.
In this case, the popular definition of demand-pull inflation — «too much money chasing too few goods» — applies quite literally.
Some nations' governments have done this to the detriment of their economies, rendering their currency virtually worthless.
Demand-Pull Inflation Vs. Cost-Push Inflation
Both demand-pull inflation and cost-push inflation have similar results: An increase in the prices across an economy. However, their inherent sources are different. Let's break down the differences between the two.
Cost-push inflation is not driven by aggregate demand. Instead, it is caused by the increase in production costs. Generally, this increase in production costs comes from a shortage of materials or labor. These scarcities cause production costs to rise, which results in increased prices overall. Cost-push inflation can also stem from natural resource scarcity, which can drive prices upward.
It can also come from monopolistic segments of society driving their wages above average levels, increasing overall production costs. These same monopolistic segments can also offer their goods and services to consumers at a higher price due to a lack of competitors, which also drives cost-push inflation.
Rather than prices going up because of rising demand, as in demand-pull inflation, cost-push inflation causes prices to go up because of the supply side of the equation.
Demand-Pull and Cost-Push Inflation
The term ‘inflation’ is used in many senses and it is difficult to give a generally accepted, precise and scientific definition of the term. Popularly, inflation refers to a rise in price level.
We can distinguish between two kinds of inflation on the basis of their causes, viz., demand-pull and cost-push inflation.
The most common cause for inflation is the pressure of ever-rising demand on a stagnant or less rapidly increasing supply of goods and services. The expansion in aggregate demand may be due to rapidly increasing private investment or expanding government expenditure for war or economic development.
At a time when demand is expanding and exerting pressure on prices, attempts are made to expand production. However, this may not be possible either due to non- availability of employed resources or shortages of transport, power, capital and equipment.
Expansion in aggregate demand, after the level of full employment, results into rise in the price level. In a developing economy India, resources are used for growth, for creating fixed assets and production of consumer goods. Necessarily, large expenditure will create.
large money income and large demand but without a corresponding increase in supply of real output.
In the above diagram, an increase in aggregate demand (AD) from AD1 to AD2 leads to a rise in the general price level (P) from P1 to P2. Aggregate demand could increase due to an increase in any of its components.
For instance, when households are more optimistic about the economic outlook, they will expect their income to rise and hence increase consumption expenditure. Consumption expenditure may also rise due to other factors such as an increase in the wealth of households.
A fall in interest rates will lead to more profitable planned investments resulting in an increase in investment expenditure. Investment expenditure may also rise due to other factors such as stronger business sentiment.
When the economy is in a recession, the government may increase expenditure on goods and services to steer the economy back onto the path of expansion. An increase in foreign income will lead to an increase in net exports.
We should emphasize here the role played by deficit financing and increase in money supply on the level of prices in a developing country. Often, the government of a developing country resorts to deficit spending to finance economic development i.e.
, borrowing from the central bank and commercial banks, which, in turn, leads to increase in money supply in the country. This exerts a strong pressure on the level of prices. An increase in foreign demand for the exports of a country may also raise the price level in a country.
Expansion in foreign demand and consequent expansion in exports will raise income of the people. This will push up demand for goods and services within a country. In case the additional money income is used to buy imports or is hoarded then it will not have inflationary effect in the country.
Thus, inflationary pressure is built by increasing aggregate demand in excess of the available resources. The increase in aggregate demand can be due to increase in government expenditure or increase in private investment and private consumption or release of pent up demand of consumers immediately after a war or increase in exports and so on.
Deficit financing and increase in money supply further aggregate the situation by boosting demand still further. In all these cases, inflation is the result of demand-pull factors. It must be emphasized here that demand-pull inflation cannot be sustained unless there is increase in money supply.
In certain circumstances, prices are pushed up by wage increases, forced upon the economy by labor leaders under the threat of strike. Costs can also be raised by manufacturers through a system of fixing a higher margin of profit.
The common man generally blames profiteers, speculators, hoards and others for pushing up the costs and prices. Again, the government is responsible for raising the costs by imposing new taxes and continuously raising the tax rates of existing commodity.
Therefore, rising rates of commodity taxes, in a sellers market, will enable the producers to raise the prices by the full amount of taxes.
Under conditions of rising prices, business and industrial units find it easy to pass on the burden of higher wages to the consumers by raising the prices. Thus rise in wages, profit margin and taxation are responsible for cost-push inflation.
In the above diagram, a decrease in aggregate supply (AS) from AS1 to AS2 leads to a rise in the general price level (P) from P1 to P2. The cost of production in the economy may rise independently of demand due to several reasons. For instance, workers will bargain for higher wages when they expect prices to rise or when the labour market is tight.
The prices of imported intermediate goods will rise when the exchange rate of domestic currency falls or when there is inflation in other economies. If the government increases indirect taxes such as the goods and services tax or if oil prices rise, the cost of production in the economy will rise.
For instance, the sharp rise in oil prices in the early 1970s led to a huge rise in the cost of production in the world.
In periods when wages, prices and aggregate demand are all rising and creating an inflationary situation, it is difficult to find out active and passive factor. In many cases, it is neither demand-pull inflation nor cost-push inflation, but it is a combination of both. However, it is possible and often useful to separate the dominant factors.
If aggregate demand is responsible for the inflationary situation, it may persist so long as excess demand persists and in the extreme case, it may develop into hyper-inflation come though cost-push inflation. On the other hand, cost-push inflation cannot persist for long, unless there is increase in aggregate demand.
On the other hand, if wages and prices continue to rise even when demand ceases to grow, we have cost-push inflation.