Demand Pull Inflation Definition Example Causes

Demand-Pull Inflation Definition

Key Takeaways

Demand-pull inflation is the term used to describe economic inflation brought on by high consumer demand, where total demand exceeds total supply. As a result, prices usually go up.Demand-pull inflation is caused due to consumption, exchange rate, government spending, expectations, and money growth.The advantages of demand-pull inflation are that it boosts economic growth, benefits borrowers, increases wages, and benefits lenders and the government.Demand-pull inflation has certain disadvantages, such as a fall in the money’s actual value, a reduction in the standard of living, and disadvantages to lenders due to the decrease in the money value.

Demand-Pull Inflation Graph

We can show the demand-pull inflation through the below diagram as well:

The explanation of the above demand-pull inflation graph is as follows:

The X-axis measures the aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices.read more and supply. The Y-axis measures the general price level. The curve AS represents the aggregate supply Aggregate SupplyAggregate Supply is the projected supply that a business calculates based on the existing market conditions. Various factors such as changing economic trend are considered before calculating the aggregate supply.read more that rises upward initially. Still, when a full-employment level of aggregate supply OYF is achieved, the supply curve of AS takes a vertical shape. Once full employment is completed, output supply cannot be increased.

When the aggregate demand curveDemand CurveDemand Curve is a graphical representation of the relationship between the prices of goods and demand quantity and is usually inversely proportionate. That means higher the price, lower the demand. It determines the law of demand i.e. as the price increases, demand decreases keeping all other things equal.read more is AD1, equilibrium is less than the total employment level at which the price level of OP1 arrives. If the aggregate demand increases to AD2, the price level will rise to OP2 due to excessive demand at the price of OP1.

It is also to be noted that the rise in the 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.

However, since the aggregate supply curveSupply CurveSupply curve represents the relationship between quantity and price of a product which the supplier is willing to supply at a given point of time. It is an upward sloping curve where the price of the product is represented along the y-axis and quantity on the x-axis.read more is still sloping upward, an increase in aggregate demand from AD2 to AD3 has utilized the rise in output from OY2 to OYF. If aggregate demand increases to AD4, only the price level shall rise to OP4, with the result 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 an economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more that can serve as a cause and example.

Consumption: An increase in consumption level pushes up the price of the certain product/commodityExchange Rate: DepreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year.
read more of home currency will boost exports. Hence, aggregate demand increases.Government Spending: An increase in government spending will also enable the aggregate demand in an economy.Expectations: The very anticipation of inflation will lead to a rise in inflation.Monetary Growth: If too much money is chasing too few goods, inflation will rise.

Examples of Demand-Pull Inflation

Example #1 – US Housing Price Inflation in 2006

Credit default swaps CDS full form CDS Full FormA credit default swap is a financial transaction between a third party and a buyer. where the seller guarantees to compensate the buyer if the acquired asset defaults for any reason.read more was a new insurance product that guaranteed against defaults on mortgages and other loansLoansA loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment.read more. This coverage generated demand for another innovation in ABS (Asset-based securities) ABS (Asset-based Securities)Asset-backed Securities (ABS) is an umbrella term used to refer to a kind of security that derives its value from a pool of assets, such as bonds, home loans, car loans, or even credit card payments.read more. These further allowed securities that monitored mortgage prices to be sold in the secondary market Secondary MarketA secondary market is a platform where investors can easily buy or sell securities once issued by the original issuer, be it a bank, corporation, or government entity. Also referred to as an aftermarket, it allows investors to trade securities freely without interference from those who issue them.read more like stocks and bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more.

Since all these involve complex calculations and assumptions, it led to supercomputers that executed the processing. As demand for securities rose, so did the price of underlying assetsUnderlying AssetsUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more, which were houses. The need for banks for mortgages to underwrite the derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. read more was driving housing price inflationPrice InflationA Credit Default Swap (CDS) is a financial agreement between the CDS seller and buyer. The CDS seller agrees to compensate the buyer in case the payment defaults. In return, the CDS buyer makes periodic payments to the CDS seller till maturity.read more until 2006. Subsequently, supply caught up with demand, and home prices started to fall, spiraling debtDebtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.” url=”https://www.wallstreetmojo.com/financial-crisis/”]the Global Financial crisis[/wsm-tooltip] of 2008.

At the same time, the FED over-expands the money supply by lowering the Fed Funds rate to 1% to combat recession post the dot-com bubble. Though inflation did rise to around 3.3%, housing prices rose, further enhancing the drop.

Example #2 – Economic Growth & Inflation in the UK (1980 onwards)

Another instance was the economic growthEconomic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific period.read more in the UK in the late 1980s. The below image shows the progress of economic growth of over 4%:

Source – Economicshelp.org

Inflation started to rise due to:

The rise in housing prices.Cut in real interest ratesReal Interest RatesReal interest rates are interest rates calculated after taking inflation into account. It is a means of obtaining inflation-adjusted returns on various deposits, loans, and advances, and thus reflect the real cost of funds to the borrower. read more.Reduction in the rates of income tax.Increase in consumer confidence.

Advantages

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 may 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. That, in turn, increases the economy.The benefit to borrowers – When there is inflation in the economy, the borrowers tend to benefit from the same as the cash now is worth more than the cash in the future. As a result, the borrower will manage to repay the lenders with money worth less than it originally was when they had borrowed it. In addition, inflation may tend to reduce the real value of money. Thus, the borrower tends to benefit from this, in the long run, owing to money that is being paid to be worthless.Increase in wages – An increase in demand-pull inflation that causes the general rise in price levels may also make the companies pay more salaries. If companies do not increase the wages of their staff, it shall not be good for productivity and morale. Hence, in times of rising inflation, employers tend to increase employees’ salaries to help them match the increased standard of living brought about by inflation.Benefits lenders – Suppose wages are not raised, 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 also stand to gain as they shall now be lending for the same good at a higher price and thereby collect more interest.The 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 revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more. Moreover, the real value of government debt will now be eroded by inflation, and the government will benefit from this.

Disadvantages

There are; however, certain disadvantages owing to demand-pull inflation, which are listed down as under: –

Fall in the 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 the rise in their price owing to demand-pull inflation. The value of the savings is further eroded if the inflation rate is greater than the rate of return on such reserves.Reduction in the standard of living – Demand-pull inflation increases the price of goods and commodities due to higher demand. These goods and services will now be costlier to the common consumer. They may not be able to afford the product they were regularly using earlier. Hence, inflation eats away the real power of money, and therefore consumers may be doomed to a lower standard of living.The disadvantage to lenders – Owing to a decrease in the value of money due to inflation, one will repay the lender an amount much lesser in value. Therefore, the money received would be more deficient in value and worth than what was lent originally due to a fall in the real value of money.

Limitation

If a certain product has no demand, the price increase may not be attributed to demand-pull inflation. There may be other factors too that have come into play.

Conclusion

Demand-pull inflation, as discussed, brings about a decrease in the value of money and erodes the value of savings and investments if the rate of inflationRate Of InflationThe rate of inflation formula helps understand how much the price of goods and services in an economy has increased in a year. It is calculated by dividing the difference between two Consumer Price Indexes(CPI) by previous CPI and multiplying it by 100.read more is greater than the interests or amounts earned on such investments. Therefore, reducing one to a lower standard of living may harm the economy. On the other hand, however, a certain inflation range is good for the economy as it contributes to and boosts economic growth. For this reason, many countries adopt inflation targeting-based policies to ensure inflation is channeled in the right manner to achieve the desired change as required by the government.