Definition: Demand-pull inflation is that form of inflation where an upsurge in consumer demand outperforms the supply of goods within the country. When the supply of the goods falls short to accommodate this outpaced demand, the cost of living upsurges, resulting in inflation.
Demand-pull inflation affects the country on a macro-level by increasing the consumers’ purchasing power, accelerating the production activities and suppressing unemployment. However, this boom is not a positive sign for the economic stability of the country in the long-run.
Content: Demand-Pull Inflation
Demand-Pull Inflation Diagram
The change in aggregate demand occurs due to various factors or components as denoted by the following equation:
- AD denotes Aggregate Demand;
- C denotes Consumer Expenditure;
- I denotes Investment;
- G denotes Government Spending;
- X denotes Export and;
- M denotes Import.
Demand-pull inflation can be a result of one or more above mentioned factors.
Demand-Pull Inflation (Keynesian Diagram)
Keynes explained the concept of demand-pull inflation as a condition where the demand outpaces the available resources. In other words, even the full-employment level or supply capacity fails to match the accelerating demand.
In the above graph,
- GPL denotes Gross Price Level;
- AD denotes Aggregate Demand;
- AS denotes Aggregate Supply;
- GDP denotes Gross Domestic Product and;
- Y denotes Year.
Demand-Pull Inflation (Classic Diagram)
Demand-pull inflation occurs when the demand goes higher than the supply while the economy is performing at a full-employment level. In the long run, the aggregate supply goes on increasing to fulfil the requirement.
Thus, more people are employed and higher wages are paid off, all this results in increment in the cost of production. Ultimately, the gross price of the goods or services hikes up.
In the given diagram, LRAS denotes Long-Run Aggregate Supply.
Causes of Demand-Pull Inflation
The economy experiences inflation when the demand surpasses the supply of goods within a country.
The demand-pull inflation can be seen as the result of various macro-level reasons as discussed below:
Exchange Rate Depreciation
When there is a fall in the exchange rate of a country, the imported products become expensive while the export prices diminish.
Thus, people find it cheaper to buy local goods instead of spending over pricey foreign products. This ultimately inflates the demand for locally produced goods.
Excessive Economic Growth and Consumption
As the economy accelerates, companies increase production in anticipation of better sales. This means more employment opportunities and higher pay to the staff.
Simultaneously, consumers have higher disposable income due to cheaper credit availability and increased earnings. Hence, the consumers’ purchasing power ultimately shoots up, they are to spend more on durable and luxury goods. More trade means more demand and economic boost.
High Government Spending
The government plans, investment decisions and policies result in a major economic reform. Say, the ‘Become Vocal for Local’ initiative of the Indian government opens up opportunities for the small scale industries in India. Thus, the demand for local products gradually increases within the country.
Change in Monetary Policy
The central bank plays a key role at times in major economic reforms. On encountering a slowdown in the economy, the central bank steps forward to issue more currency for increasing the disposable income of the consumers. Hence, consumer demand and overall trade activities go up.
Technology or Innovation
Sometimes an innovative product or idea becomes a trend and therefore, widely influences the consumers. The demand for such a product or service rapidly escalates to cause inflation in the country.
Anticipation of Future Inflation
When consumers get to know about a future possibility of inflation, they tend to stock more today. Thus, the present demand for products shows an upward trend. All this results in higher demand than supply. This situation altogether contributes to demand-pull inflation.
Measures to Control Demand-Pull Inflation
Inflation leaves a long-lasting impact over a country’s economy. However, the demand-pull inflation rectifies by itself many times. Though, the government and the central bank have come forward with the following steps to control it:
Monetary Policy Measures
The central bank together with the government uses monetarism as a means of rectification when it comes to demand-pull inflation. The following two ways are most commonly adopted:
Reducing Budget Deficit: The central government takes the necessary steps to reduce its expenditure and increase the revenue to cut short the deficit.
Increasing Interest Rates: The central bank raises the interest rates on both loans and savings. Thus, high borrowing rates discourage consumers to take loans, while impressive interest on deposits attracts them to invest more.
Fiscal Policy Measures
The government’s non-monetary stand to regulate the country’s economy such as tax reforms and government spendings. Let us explain each of these measures below:
Raising Taxes: The government levies a higher income tax and GST (Goods and Service Tax) to ensure low disposable income in the hands of consumers. It also raises the price of products and services so that consumers buy less.
Reducing Government Spendings: The government spends less over the infrastructure, trade, employment, education and other macro-level projects. This discourages any further growth of the economy and thus, regulates demand-pull inflation.
Demand-Pull Inflation Example
Let us discuss the case of US housing price inflation that took place in the year 2006.
It was back then, the Credit Default Swaps (CDS) came up as an innovative insurance product that took the US market by fire. Being a guarantee against mortgage or default, it encouraged people to take more loans.
Also, Asset-Based Securities (ABS) were introduced to further allow trading of these mortgage assets (mostly houses) in the secondary market. With the rise in the demand of these ABS, the price of the mortgage assets went up.
All this resulted into housing price inflation which stabilized after 2 years in the year 2008 when the world encountered financial crises and the demand for property reduced to such an extent it was easily met by the supply capacity.