Demand-Pull Inflation

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What is 'Demand-Pull Inflation'

Demand-pull inflation is used by Keynesian economics to describe what happens when price levels rise because of an imbalance in the aggregate supply and demand. When the aggregate demand in an economy strongly outweighs the aggregate supply, prices go up. Economists describe demand-pull inflation as a result of too many dollars chasing too few goods.

Demand-pull inflation results from strong consumer demand. Many individuals purchasing the same good will cause the price to increase, and when such an event happens to a whole economy for all types of goods, it is called demand-pull inflation.

BREAKING DOWN 'Demand-Pull Inflation'

In Keynesian theory, an increase in employment leads to an increase in aggregate demand. Due to the increase of demand, firms hire more people to increase their output. The more people firms hire, the more employment increases. Eventually, output by firms becomes so small that the prices of their goods rise.

Demand-Pull Inflation In Contrast with Cost-Push Inflation

Cost-push inflation is when price and wage go up and are transferred from one sector of the economy to another. Though they move in practically the same manner, they work on a different aspect of the whole inflationary system. Demand-pull inflation shows how price rise starts, while cost-push inflation portrays why inflation is is difficult to stop once it begins.

The main idea behind demand-pull inflation is that consumer demand that outweighs aggregate supply greatly drives inflation. In a market where there are a particular number of goods and a huge demand for those goods, the prices of those goods have to rise.

Causes of Demand-Pull Inflation

There are five causes for demand-pull inflation:

  1. A growing economy: When consumers feel confident, they will spend more, take on more debt by borrowing more. This leads to a steady increase in demand, which means higher prices.  
  2. Asset inflation: a sudden rise in exports which then translates to an undervaluation of the involved currencies
  3. Government spending: when the government opens up its pocketbooks, it drives up prices. Military spending prices may go up when the government starts to buy more military equipment.
  4. Inflation expectations: forecasts and expectations of inflation, where companies increase their prices to go with the flow of the expected rise
  5. More money in the system: demand-pull inflation is produced by an excess in monetary growth or an expansion of the money supply. Too much money in an economic system with too few goods makes prices increase

Example of Demand-Pull Inflation

When oil refineries work at full capacity, they cause demand-pull inflation. Environmental concerns cause regulatory problems for refineries. Because of prohibitive factors by the government, supply created by oil refineries is also limited. Rather than a lack of oil or the lack of companies to produce oil, restrictive legislation prevents the market from provided optimum efficiency in producing goods with high demand. The oil industry, then, is one of the biggest contributors of demand-supply inflation.

During the U.S. economic downturn and the eurozone debt crisis, concerned investors turned to gold, buying the precious metal as a hedge against a collapse in the U.S. dollar and the euro, increasing demand for the commodity.