What is Demand-Pull Inflation?

Demand-pull inflation is like an Easter egg hunt…

Imagine hiding 200 dyed eggs in a park. When you blow the whistle, dozens of children go racing around, trying to get as many eggs as they can. After 10 minutes of hunting, the eggs are gone. If 50 kids are participating, each child will get an average of four eggs. If there were twice as many participants, everyone ends up with half as many eggs for about the same effort. Because more people (dollars) are chasing the same amount of eggs (products), everyone gets fewer eggs for their effort (purchasing power goes down).

Demand-pull inflation is a general increase in the price of all products in an economy, driven by increased consumption. It shouldn’t be confused with changing prices of specific products. Microeconomics evaluates the way that people and businesses react to changing conditions that impact one good or service.

If a material shortage increases the cost of producing one product, the price might be driven higher. When the price of a single product increases, that is not inflation.

Rather than looking at how buyers and sellers act around one product, macroeconomics looks at the aggregate supply and demand of all buyers and sellers. Inflation is a macroeconomic concept that looks at prices across the entire economy, which means that consumers can’t just switch to substitute products to maintain their purchasing power.

For example, if the cost of a cup of coffee doubles, you might just switch to tea. If the price of coffee and tea both double, that may be inflation, which reduces your ability to buy either one.

Inflation comes in two main forms — demand-pull and cost-push. Demand-pull inflation comes from people having more money to spend, thus increasing the aggregate demand for goods and services faster than the economy can add more products to satisfy the increased demand.

Demand-pull inflation happens whenever consumers increase the number of products they want to buy faster than sellers can add those products to the marketplace. Mathematically, demand-pull inflation can occur if any of the components of aggregate demand (household consumption, investment, government spending, and net exports) increase the desired consumption level beyond the economy’s productive capacity.

When people have more money, they tend to spend more money. Therefore, anything that increases income, wealth, or job security can result in people buying more. If the economy is growing, the unemployment rate falls as more people get jobs. Those jobs come with paychecks, which people use to make purchases.

People also feel more confident about their ability to keep getting paid, which can lead them to spend more and save less. All of this increased spending results in an increase in aggregate demand. If the economy can’t increase production fast enough to meet the higher demand, that can result in demand-pull inflation.

Poorly timed monetary policy (the Federal Reserve’s actions to control the interest rate) can also lead to demand-pull inflation. When the Federal Reserve increases the money supply, it puts more money into the banking system. That tends to increase consumption.

Investment refers to the expenditures by businesses in long-term assets, like buildings and equipment. If investment increases, it increases the number of sales for the manufacturers of equipment and suppliers of materials. It also increases the number of people working to create those buildings and pieces of equipment. All of this new spending can cause demand-pull inflation.

When the government spends money, it buys products from businesses and pays wages to public employees. If the government increases spending, the aggregate demand for goods and services goes up. Poorly timed fiscal policy (changing government spending levels and tax rates) can push aggregate demand past what the economy can provide — which would result in demand-pull inflation.

The difference between the value of the products a country exports (ships to other countries) and the products it imports (buys from other countries) is called net exports. When a country’s net exports increase, that means demand for its products has gone up. That can happen because of a change in exchange rates, or because of a change in international trade policies. Such an increase in aggregate demand can pull prices upward.

Demand-pull inflation happens when people want to buy more; in contrast, cost-push inflation is a result of rising costs of doing business. While individual products react differently to changing market conditions, there are situations in which a change hits several industries at once. When that happens, inflation sometimes follows.

For example, if the economy is growing, many people have more money to spend. That leads to the increased consumption of many products. Consequently, the economy might see demand-pull inflation.

In another situation, a dramatic increase in the price of oil, for example, could make shipping every product more expensive. The higher cost of delivering products to consumers results in higher prices across the board. That’s cost-push inflation.

Cost-push inflation is especially troublesome, as it can create stagflation (the simultaneous increase in unemployment levels and prices). The easiest way to know if inflation is cost-push vs. demand-pull is to consider whether it was supply or demand factors that changed. Cost-push comes from the supply side. Demand-pull comes from changes in demand.

Inflation occurs if aggregate demand outpaces aggregate supply. It’s especially prevalent if the economy is trying to produce beyond its natural output (the amount of production the economy’s resources can sustain in the long-run). If the economy is producing too much, it’s like pushing an engine too hard. Eventually, it breaks down.

But if you’re only in second gear, you can shift to third and gain speed without hurting the engine. Likewise, if the economy is coming out of a recession, there is idle labor and capital to put to work without creating much inflation. But if the economy is running at full capacity, trying to grow it further would result in demand-pull inflation.

There is a well-established inverse relationship between demand-pull inflation and unemployment, which is known as the Phillips curve. If unemployment is high, there are idle resources capable of growing the economy without much risk of demand-pull inflation. But if the unemployment rate is low, the risk of demand-pull inflation is high. The Federal Reserve attempts to balance this trade-off between unemployment and inflation, knowing that fighting one can create more of the other.

The wage-price spiral refers to the feedback loop that results from the fact that wages are part of the cost of business. If wages increase, the cost of production increases as well. Those higher costs of doing business result in higher prices (inflation) for consumers. But those consumers are, in aggregate, the same people receiving the paychecks.

Therefore, the additional income from rising wages is met with higher prices for the things workers buy. If this scenario repeats itself, you could end up in a never-ending cycle of increasing prices and wages. Consequently, you might end up using a higher income to buy the same amount of goods as before.

Most people think about inflation as a bad thing. After all, nobody wants to pay more for the things they buy. But a little bit of demand-pull inflation can be good for the economy. Here are some pros and cons.

• It stimulates the economy, encouraging people to buy things before the price goes up.
• It is a result of high levels of employment, which is a positive.
• It benefits borrowers, allowing them to repay debts with less valuable dollars.

• It increases the prices of the things people buy, reducing their purchasing power.
• It distorts the value of money, making it hard to interpret changing prices and wages.
• It increases borrowing costs, since banks now will demand a higher interest rate to make up for the value of money lost to inflation.