A Business Encyclopedia

Demand-pull Inflation

Definition: The Demand-pull Inflation occurs when, for a given level of aggregate supply, the aggregate demand increases substantially. In other words, demand-pull inflation exists when the aggregate demand increases rapidly than the aggregate supply.

The increase in aggregate demand may be due to:

  • Monetary Factors, i.e., an increase in the supply of money
  • Real Factors, i.e., an increase in the demand for real output

Demand-pull Inflation due to Monetary factors: The increase in money supply more than the increase in potential output is one of the major reasons for demand-pull inflation. Let’s see how the money supplies causes the demand-pull inflation. At a given level of output, when the monetary and real sectors are in equilibrium, then the economy is also in equilibrium. Since the economy is in general equilibrium, the general price level corresponding to it is called as equilibrium price level.

With an increase in the money supply, the other things remaining the same, the real stock of money at each price level increases. As a result, the interest rate decreases and the people’s desire to hold money increases. With a decrease in the interest rates, the investment also increases, which leads to more income.

The increase in income causes an increase in the consumption expenditure and thus, a rise in investment and consumption expenditure increases the aggregate demand and aggregate supply, other things remaining the same. This increase in the aggregate demand is exactly proportional to the increase in the money stock. Thus, a rise in aggregate demand, for a given level of aggregate supply, leads to an increase in the general price level in the economy, which may be inflated.

Demand-pull Inflation due to Real Factors: The following are some of the real factors that cause demand-pull inflation in the economy:

  • Increase in government expenditure without any change in the tax revenue.
  • Cut in the tax rates without any change in the government expenditure.
  • Upward shift in the Investment Function
  • Downward shift in the Saving Function
  • Upward shift in the Export Function
  • Downward shift in the Import Function.

The first four factors directly contribute towards an increase in the level of disposable income. Since the aggregate demand being the function of income, an increase in aggregate income leads to an increase in the aggregate demand, thereby causing the demand-pull inflation. Let’s see how real factors cause demand-pull inflation.

Suppose, the government increases its spending financed through external borrowings from abroad. The rise in government expenditure generates additional demand and thus, the aggregate demand increases.  Since it is assumed that there is full employment, then the additional resources can be acquired only by bidding a higher price. As a result, the prices rise while the output remains unchanged.

Thus, the transaction of demand for money increases and in order to meet the increased demand for money people sell their financial assets such as bonds and securities. Eventually, the prices of bonds and securities go down and the rate of interest increases. In the product market, the price rises to such a level that the additional spending by the government is absorbed by such price rise. This shows that the real factors also cause inflation.

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