Demand-pull inflation is a period of inflation which arises from rapid growth in aggregate demand. It occurs when economic growth is too fast.
If aggregate demand (AD) rises faster than productive capacity (LRAS), then firms will respond by putting up prices, creating inflation.
- Inflation – a sustained increase in the price level.
- Demand-pull inflation – inflation caused by AD increasing faster than AS.
Demand-pull inflation means:
- Excess demand and ‘too much money chasing too few goods.’
- The economy is at (or ver close to) full employment/full capacity.
- The economy will be growing at a rate faster than the long-run trend rate.
- A falling unemployment rate.
How demand-pull inflation occurs
AD increases faster than LRAS – causing inflation.
If aggregate demand is rising at 4%, but productive capacity is only rising at 2.5%; firms will see demand outstripping supply. Therefore, they respond by increasing prices.
Also, as firms produce more, they employ more workers, creating a rise in employment and fall in unemployment. This increased demand for workers puts upward pressure on wages, leading to wage-push inflation. Higher wages increase the disposable income of workers leading to a rise in consumer spending.
Economic growth and long-run trend rate
The long trend rate of economic is the sustainable rate of economic growth; it is the rate of economic without any demand-pull inflation. If economic growth exceeds this long-run trend rate, then it will cause inflationary pressures.
In a boom, growth is above the long-run trend rate, and it is in this situation where we will get demand-pull inflation.
Causes of demand-pull inflation
- Lower interest rates. A cut in interest rates causes a rise in consumer spending and higher investment. This boost to demand causes a rise in AD and inflationary pressures.
- A rise in house prices. Rising house prices create a positive wealth effect and boost consumer spending. This leads to a rise in economic growth.
- Rising real wages. For example, unions are bargaining for higher wage rates or shortage of workers in the labour force.
- Devaluation. Devaluation in the exchange rate increases domestic demand (exports cheaper, imports more expensive). Devaluation will also cause cost-push inflation (imports more expensive)
- Strong levels of confidence encouraging more spending and lower saving levels.
- Increase in money supply. A rise in bank lending, quantitative easing can all cause more money flowing in the economy.
Demand pull inflation and Phillips Curve
Demand-pull inflation can also be shown on a Phillips Curve. A rise in demand causes a fall in unemployment (from 6% to 3%) but an increase in inflation from inflation of 2% to 5%.
Examples of demand pull inflation
From 1986 to 1990, inflation increased to 10%. This was an example of demand-pull inflation. In that period, the UK had rapid economic growth. Quarterly growth figures of 1-2%, mean the annualised growth rate would be 4 times that – 4-8% a year, which is far higher than the UK’s long-run trend rate.
In the late 1980s, the chancellor Nigel Lawson believed there had been a supply side miracle and the economy could grow faster. Interest rates were kept relatively low, house prices soared, taxes were cut and confidence was high. All this caused higher demand, but also rising inflation.
The inflation of the late 1970s was due primarily to cost-push factors (wages/oil prices of 1970s)
UK 1980s
The rapid growth in demand saw inflationary pressures increase.
US late 1960s
US Inflation: St Louis Fed
Rapid economic growth in the mid-1960s, caused inflation to increase from 2% in 1966 to 6% by 1970.
Was the Inflation of 2022 Demand-pull?
In 2022/23 inflation rose. It was a combination of
- Supply constraints at the end of Covid – shipping costs soared
- Rising oil and gas prices – causing cost-push inflation
- Strong demand at the end of Covid, households and surplus saving they wanted to spend.
So there was an element of demand-pull inflation, but it was also cost-push
Demand pull inflation and other types of inflation
Demand pull inflation could occur with:
- Cost-push inflation (rising costs of production). For example, in the early 1970s, economic growth and rising oil prices caused a spike in US inflation of 12% by 1974.
- Built-in inflation. Inflation has its own momentum. High inflation in previous years, makes future inflation more likely as firms put up prices in anticipation of repeated inflation.
Decline of demand pull inflation
In recent years, demand-pull inflation has become quite rare. The small rises in inflation (2008/2001) were primarily due to cost-push factors. In recent decades, we have not witnessed any significant demand-pull inflation. this is due to several factors
- Independent Central Banks responsible for monetary policy and keeping inflation to a target of 2%
- Secular stagnation. Lower rates of economic growth
- Downward pressure on prices from the global economy. Deflation of manufactured goods in Asia.
- New technology leading to lower prices.
- See also: fall in global inflation
Related
About The Author
This Whole Inflation Thing Gets Me Really Confused.
1. Why Should Increase in Workers’ Wages Increase Inflation? I Thought Disposable Income Is Supposed To Help The Economy Grow 🤷♀️
2. Why Should A Fall In Unemployment Increase Inflation? I Thought With Ppl Gainfully Employed, This Would Grow The Economy? 🤷♂️
3. When Aggregate Demand Falls Short Of Aggregate Supply, Why Should Firms Increase Prices Rather Than Increase Workers For Supply To Match Demand ???
1. Higher wages increases demand. Higher demand causes inflation
2. More employment higher demand. Upwwrd pressure on wages.