Demand pull inflation

Inflation is a sustained rise in prices, measured on a monthly basis. There are two causes of inflation:

Causes of inflation

                                               Demand-pull                                                               Cost-push

Demand-pull inflation

Demand-pull inflation is caused by excess demand in the economy.  This occurs when there is too much money chasing too few goods. Firms are unable to produce sufficient goods to meet the demand in the market. As a result firms will seek to ration the supply of goods by raising prices.

The diagram below shows the effect of an increase in income. The rise in income causes a shift in aggregate demand to the right (AD – AD₁). The shift in demand cannot be met by firms at the existing price. As a result, prices will rise from P – P₁.

Keynesian analysis identifies demand pull inflation as one of the causes of inflation. According to Keynesian analysis demand pull inflation can only occur at full employment. At full employment an increase in aggregate demand will not be matched by an increase in aggregate supply. Firms will be able to increase supply to some extent as the equilibrium moves towards full capacity.  In order to do this, firms will expect to receive a higher price. This will result in price rising from P to P_1.

The monetarist perspective is that demand pull inflation is the only cause of inflation. This view is encapsulated in Milton Friedman’s statement, ‘Inflation is always and everywhere a monetary phenomenon.’

Circumstances which can lead to demand pull inflation

1. A growing economy may increase consumer confidence. They may feel that they can get better paid jobs and that property prices may increase if they are homeowners. Positive perceptions about the management of the economy may fuel this perception. If this situation occurs consumers may decide to increase spending and reduce savings. The level of borrowing may also increase. Firms may also respond similarly if business confidence increases. They may increase investment levels. If borrowing levels are constrained this can have a beneficial effect on the economy, since this can result in a gradual and steady rise in prices.

2. The expectation of inflation can also lead to demand pull inflation. This is because if people anticipate that inflation will increase then they may buy things before prices rise. When this happens demand may increase creating demand pull inflation. Inflationary expectation is difficult to eradicate, which is why central banks like the Bank of England set out a clear mandate to limit the increase inflation and set out an inflation target.

3. Demand pull inflation can also be created by discretionary fiscal policy. For example if the government spends more on defence this may lead to the price of military equipment rising. Alternatively if the government reduces taxation, this will increase disposable income which may lead to higher levels of consumption of goods and services. The government has announced plans for a housebuyers ISA, due to be launched in December, 2015. Under this scheme first time buyers will be able to get a 25% on their savings to put towards a deposit. This means that if you save £12,000, the government will give you £3,000 extra. This measure may well increase demand for housing, so that demand exceeds supply, resulting in inflation.

4. Technological innovation. New products may enable firms to charge higher prices, whether it be for a new car or a new smartphone. Sustained innovation can fuel continuing price rises.

5. Strength of brands. Marketing can create strong demand for a particular product. Apple products have a loyal following and people will queue up to buy the latest gadget released by the company. As a result of the strength of the brand, the price of products made by Apple tends to be higher than for rival products, which may contribute to demand pull inflation.