Politics & Society

What Is Demand-Pull Inflation? Learn About Demand-Pull Inflation in Economics With Examples

Written by MasterClass

May 14, 2019 • 3 min read

In a healthy economy, prices rise over time. This phenomenon of steadily higher prices is known as inflation, and controlled inflation is a sign of economic growth. Central banks, such as the United States Federal Reserve, set their fiscal policy to maintain a consistent inflation rate, typically around two percent per year.

Price inflation occurs for a variety of reasons. When consumer demand is the cause of increased prices, it is known as demand-pull inflation.

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What Is Demand-Pull Inflation?

Demand-pull inflation is the type of inflation that results when an economy’s aggregate demand exceeds its aggregate supply. To put this in simple terms, when production cannot keep up with consumer demand, higher prices quickly follow.

In Keynesian economics (named for the English economist John Maynard Keynes), aggregate demand increases as an economy approaches full employment. The overall supply of money increases in the form of workers’ disposable income and consumers increase their discretionary spending—purchasing items that they may consider luxuries (electronics, fancy cars) rather than necessities (food, shelter). Such a trend is a reliable cause of demand-pull inflation.

What Causes Demand-Pull Inflation?

There are four economic sectors that can serve as causes of inflation: household spending, business spending, government spending, and foreign investment.

  • Household spending increases when consumers feel confident about the economic growth rate. When this happens, they may feel more secure about making discretionary purchases (whether that’s a fancy pair of shoes or a new car), which jostles the consumer price index. As a general rule, when consumers suddenly increase demand for a particular product, its price will rise with similar suddenness.
  • Business spending increases when a nation’s gross domestic product increases. For instance, if the economy is healthy and consumers spend more money on travel, it’s conceivable that manufacturers may decide to build more aircraft. The raw materials that comprise these aircraft—various metals and plastics—will experience aggregate demand increases, and thus will inflate in price.
  • Government spending can lead to inflation when monetary policy is designed to stimulate an economy. If a nation is experiencing a recession, its government may seek to energize the economy by making investments—in infrastructure, in new employees, in educational programs. These investments inject new capital into the market, and cause prices to rise.
  • Foreign investment occurs when one country’s exchange rate favors buyers from a different country. For instance, if American buyers view Thai real estate as a bargain, they will begin purchasing properties in Thailand, which causes demand-pull inflation in the Thai market. This is especially prevalent when the exchange rate between the American dollar and the Thai Baht favors the dollar.

How Does Demand-Pull Inflation Impact Unemployment?

A general economic theory states that inflation has an inverse relationship to unemployment rates. As an overall rule:

  • The more people who are working, the more money is transferred to individuals in the form of salaries.
  • The more money people make in salaries, the more they have for discretionary spending.
  • The higher the rate of discretionary spending, the higher the rate of inflation.
  • The higher the rate of inflation, the higher general price level within the economy.

This concept can be simply illustrated by the Phillips Curve, named for the New Zealand economist William Phillips.

PhilCurve

Source: EnWiki https://creativecommons.org/licenses/by-sa/3.0/deed.en

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What Is the Difference Between Demand-Pull Inflation and Cost-Push Inflation?

There are other types of inflation beyond demand-pull inflation. For example, cost-pull inflation (CPI) results when the aggregate supply of goods and services decreases because of an increase in production costs. For instance, if low-paid workers in a factory form a union and demand higher wages, it’s possible the factory owner will simply shut down the business in response. This leads to decreased manufacturing and higher prices in the market. This differs from demand-pull inflation because it’s the producer, not the consumer, who is the root cause of inflation.

What Is the Wage-Price Spiral?

The relationship between rising labor costs and inflation can be described by the wage-price spiral. The wage-price spiral combines the concepts of cost-push inflation and demand-pull inflation. Increased wages lead to cost-push inflation, while increased demand leads to demand-pull inflation. The two feed off each other and create this veritable “spiral”:

  • Rising wages increase disposable income for workers.
  • More disposable income leads to greater demand for discretionary goods and services.
  • The increased demand for goods and services causes prices to rise.
  • Rising prices prompt workers to demand higher wages.
  • The higher wages lead to higher production costs and the cycle repeats.

Learn more about economics and society with Paul Krugman.