What Is Demand-Pull Inflation?

Demand Pull Inflation

Investopedia / Xiaojie Liu

What Is Demand-Pull Inflation?

Inflation is a general rise in the price of goods in an economy. Demand-pull inflation causes upward pressure on prices due to shortages in supply, a condition that economists describe as "too many dollars chasing too few goods." An increase in aggregate demand can also lead to this type of inflation.

In Keynesian economics, an increase in aggregate demand may be caused by a rise in employment, as companies need to hire more people to increase their output. A tight labor market means higher wages, which translates into greater demand.

Demand-pull inflation can be compared with cost-push inflation.

Key Takeaways

  • Inflation is thought to be caused by different mechanisms.
  • When aggregate demand surpasses available supply, higher prices are the result. This is demand-pull inflation.
  • A low unemployment rate is unquestionably good in general, but it can cause inflation because more people have more disposable income.
  • Increased government spending is good for the economy, too, but it can lead to scarcity in some goods and inflation will follow.
  • Another explanation is cost-push inflation, whereby costs of production increase and higher prices are passed on to consumers.

Demand-Pull Inflation

Understanding Demand-Pull Inflation

The term demand-pull inflation usually describes a widespread phenomenon. That is, when consumer demand outpaces the available supply of many types of consumer goods, demand-pull inflation sets in, forcing an overall increase in the cost of living.

Demand-pull inflation is a tenet of Keynesian economics that describes the effects of an imbalance in aggregate supply and demand. When the aggregate demand in an economy strongly outweighs the aggregate supply, prices go up. This is the most common cause of inflation.

In Keynesian economic theory, an increase in employment leads to an increase in aggregate demand for consumer goods. In response to the demand, companies hire more people so that they can increase their output. The more people firms hire, the more employment increases. Eventually, the demand for consumer goods outpaces the ability of manufacturers to supply them.

Causes of Demand-Pull Inflation

There are five primary causes of demand-pull inflation:

  1. A growing economy: When consumers feel confident, they spend more and take on more debt. This leads to a steady increase in demand, which means higher prices.  
  2. Increasing export demand: A sudden rise in exports forces an undervaluation of the currencies involved.
  3. Government spending: When the government spends more freely, prices go up.
  4. Inflation expectations: Companies may increase their prices in expectation of inflation in the near future.
  5. More money in the system: An expansion of the money supply with too few goods to buy makes prices increase.

Demand-Pull Inflation vs. Cost-Push Inflation

Cost-push inflation occurs when money is transferred from one economic sector to another. Specifically, an increase in production costs such as raw materials and wages inevitably is passed on to consumers in the form of higher prices for finished goods.

Demand-pull and cost-push inflation move in practically the same way but they work on different aspects of the system. Demand-pull inflation demonstrates the causes of price increases. Cost-push inflation shows how inflation, once it begins, is difficult to stop.

In good times, companies hire more. But, eventually, higher consumer demand may outpace production capacity, causing inflation.

Demand-Pull Inflation Example

Say the economy is in a boom period, and the unemployment rate falls to a new low. Interest rates are at a low point, too. The federal government, seeking to get more gas-guzzling cars off the road, initiates a special tax credit for buyers of fuel-efficient cars. The big auto companies are thrilled, although they didn't anticipate such a confluence of upbeat factors all at once.

Demand for many models of cars goes through the roof, but the manufacturers literally can't make them fast enough. The prices of the most popular models rise, and bargains are rare. The result is an increase in the average price of a new car.

It's not just cars that are affected, though. With almost everyone gainfully employed and borrowing rates at a low, consumer spending on many goods increases beyond the available supply. That's demand-pull inflation in action.

What Is Meant by Demand-Pull in Economics?

Economists suggest that prices can be pulled higher by an increase in aggregate demand that outstrips the available supply of goods in an economy. The result can be inflation.

What Are the 3 Types of Inflation?

Inflation is sometimes classified into three types: demand-pull inflation, cost-push inflation, and built-in inflation. Built-in inflation is an alternative explanation for rising prices that differs from cost-push and demand-pull theories, which highlights the role of expectations for future inflation by consumers and businesses.

How Does Inflation Impact the Economy?

Inflation can affect the economy in several ways. For example, if inflation causes a nation’s currency to decline, this can benefit exporters by making their goods more affordable when priced in the currency of foreign nations.

On the other hand, this could harm importers by making foreign-made goods more expensive. Higher inflation can also encourage spending, as consumers will aim to purchase goods quickly before their prices rise further. Savers, on the other hand, could see the real value of their savings erode, limiting their ability to spend or invest in the future.

The Bottom Line

Demand-pull inflation explains rising prices in an economy as the result of increased aggregate demand that surpasses supply. As consumers demand more given limited supply, prices are bid higher. Demand-pull inflation can be contrasted with cost-push inflation, whereby higher costs of production are passed on to consumers.

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