Demand-Pull Inflation: Definition, How It Works, Causes, vs. Cost-Push Inflation

What Is Demand-Pull Inflation?

Demand-pull inflation occurs in an economy when demand for goods and services exceeds supply. While demand increases, the supply of goods and services available for purchase may remain the same or drop.

Demand-pull inflation causes upward pressure on prices due to shortages in supply, a condition that economists describe as too many dollars chasing too few goods. An increase in aggregate demand can also lead to this type of inflation. Demand-pull inflation can be compared with cost-push inflation.

How Demand-Pull Inflation Works

Demand-pull inflation describes a widespread phenomenon that occurs when consumer demand outpaces the available supply of many consumer goods. When demand-pull inflation sets in, it forces an overall increase in the cost of living.

Demand-pull inflation is a tenet of Keynesian economics that describes the effects of an imbalance in aggregate supply and demand. When the aggregate demand in an economy strongly outweighs the aggregate supply, prices go up. This is the most common cause of inflation.

In Keynesian economics, an increase in employment leads to an increase in aggregate demand for consumer goods. In response to the demand, companies hire more people so that they can increase their output. The more people firms hire, the more employment increases. Eventually, the demand for consumer goods outpaces the ability of manufacturers to supply them.

Causes of Demand-Pull Inflation

There are five primary causes of demand-pull inflation:

1. A growing economy: When consumers feel confident, they spend more and take on more debt. This leads to a steady increase in demand, which means higher prices.
2. Increasing export demand: A sudden rise in exports forces an undervaluation of the currencies involved.
3. Government spending: When the government spends more freely, prices go up.
4. Inflation expectations: Companies may increase their prices if they anticipate inflation.
5. More money in the system: An expansion of the money supply with too few goods to buy makes prices increase.

Demand-Pull Inflation vs. Cost-Push Inflation

Cost-push inflation occurs when money is transferred from one economic sector to another. Specifically, an increase in production costs, such as raw materials and wages, is inevitably passed on to consumers in the form of higher prices for finished goods.

Demand-pull and cost-push inflation move in practically the same way, but they work on different aspects of the system. Demand-pull inflation demonstrates the causes of price increases. Cost-push inflation shows how inflation, once it begins, is difficult to stop.

Example of Demand-Pull Inflation

Here’s a hypothetical example to show how demand-pull inflation works. Let’s assume the economy is in a boom period, and the unemployment rate falls to a new low. Interest rates are at a low point, too. The federal government, seeking to get more gas-guzzling cars off the road, initiated a special tax credit for buyers of fuel-efficient cars. The big auto companies are thrilled, although they didn’t anticipate such a confluence of upbeat factors all at once.

Demand for many models of cars goes through the roof, and the manufacturers literally can’t make them fast enough. The prices of the most popular models rise, and bargains are rare. The result is an increase in the average price of a new car.

It’s not just cars that are affected, though. With almost everyone gainfully employed and borrowing rates at a low, consumer spending on many goods increases beyond the available supply. That’s demand-pull inflation in action.

The Bottom Line

Demand-pull inflation explains rising prices in an economy as a result of increased aggregate demand that surpasses supply. As consumers demand more from a given limited supply, prices go higher. Demand-pull inflation can be contrasted with cost-push inflation, whereby higher costs of production are passed on to consumers.