Demand-pull inflation exists when aggregate demand for a good or service outstrips aggregate supply. It starts with an increase in consumer demand. Sellers meet such an increase with more supply. But when additional supply is unavailable, sellers raise their prices. That results in demand-pull inflation, also known as "price inflation."
It is the most common cause of inflation. The other reason, cost-push inflation, is rarer. It starts with a decrease in total supply or an increase in the cost of that supply. Suppliers raise prices because they know consumers will pay it. That situation is called "inelastic demand."
Six Causes of Demand-Pull Inflation
There are six causes of demand-pull inflation
1. A Growing Economy
The first is a growing economy. When families feel confident, they spend more instead of saving. They expect to get raises and better jobs. They know their homes and other investments will increase in value. They feel that the government is doing the right thing in guiding the economy. They will also borrow more, either with auto or home loans, or credit cards. If they don't borrow too much, this is a healthy cause of inflation. It creates gradual and steady price increases.
2. Expectation of Inflation
Former Federal Reserve Chairman Ben Bernanke explained it this way. Once people expect inflation, they will buy things now to avoid higher future prices. That increases demand, which then creates demand-pull inflation. Once the expectation of inflation sets in, it's hard to eradicate. For example, businesses expected higher interest rates and inflation in the 1970s. That created galloping inflation. At the same time, President Nixon imposed wage-price controls which slowed economic growth. The combination created stagflation.
As U.S. Federal Reserve chairman, Bernanke set an inflation target of 2 percent. That supports a healthy economic growth rate of between 2 - 3 percent. The target uses the core inflation rate. It eliminates volatile food and energy costs.
3. Over-Expansion of the Money Supply
That's when there is too much money chasing too few goods. That occurs when the government prints too much money. It does this to pay off its debt. Oversupply of money is the primary driver of hyperinflation. It can also occur if the Fed puts too much credit into the banking system.
4. Discretionary Fiscal Policy
Government spending drives up demand according to Keynesian economic theory. For example, military spending raises prices for military equipment. When the government lowers taxes, it also drives demand. Consumers have more discretionary income to spend on goods and services. When that increases faster than supply, it creates inflation. For example, tax breaks for mortgage interest rates increased demand for housing. Government sponsorship of mortgage guarantors Fannie Mae and Freddie Mac also stimulated demand. Although there were many other reasons for the housing bubble, they wouldn't have been as attractive without government fiscal policies.
5. Strong Branding
Marketing can create high demand for certain products, a form of asset inflation. A great example is Apple products, including the iPod, iPad, and iPhone. Prices for these goods are higher than comparable products. That's because the consumer feels Apple understands their needs, including emotional ones. There is a certain cachet to owning an Apple product. That allows Apple to charge higher prices.
6. Technological Innovation
A company that creates a new technology owns the market until other companies figure out how to copy it. People will demand products with technologies that create real improvement in their daily lives. The new technology also creates a cachet for those who must own the latest gadget. For example, Tesla's electric sports car was a technological breakthrough. It used new advanced motors, powertrains, and battery packs. It is so successful that it sells these parts to other auto companies.
Examples of Demand-Pull Inflation
Another example of technological innovation was in financial products. Credit default swaps were a new type of insurance product. They guaranteed against default on mortgages and other kinds of loans. This coverage generated higher demand for another innovation, asset-backed securities. These allowed securities that tracked the prices of mortgages to be sold on a secondary market, much like stocks.
These securities could not have been created without another technological innovation, super-computers. They process the value of these complex derivatives. As demand for the securities rose, so did the price of the underlying assets, houses. When inflation only hits one asset category, it's known as "asset inflation." Banks' demand for mortgages to underwrite the derivatives drove housing price inflation until 2006. That's when supply finally caught up with demand and home prices started to fall. It helped create the financial crisis of 2008.
The Fed overexpanded the money supply at the same time. It lowered the fed funds rate to 1 percent in 2003 to combat the recession. It remained there for a year. Inflation rose to 3.3 percent. Housing prices rose more, creating a bubble.
Deregulation allowed banks to push mortgages onto everyone. When people could borrow for almost nothing, and needed no money down, it made no sense to rent. With low-interest rates, homeowners used their homes as ATMs. They spent their home equity on medical care, housing, and consumer goods. But inflation only showed up in home prices and healthcare. The price of everything else didn't rise, thanks to China. It kept its currency, the yuan, pegged to the dollar. That artificially lowered the prices of its exports to the United States.
After the 2008 financial crisis, asset inflation occurred in gold and oil prices. Deflation occurred in housing prices and personal income. Demand-pull inflation continued in gold prices until they reached a record. That was $1,918 an ounce in August 2011. Demand for gold rose as investors worried about the eurozone crisis and the U.S. debt default crisis. As a result, they bought gold as a hedge against a collapse of either the dollar or the euro.
Frequently Asked Questions (FAQs)
How does demand-pull inflation create higher prices?
Demand-pull inflation creates higher prices, because it shifts the demand curve to the right. More buyers want more products and services. If the supply doesn't increase proportionally to demand, then buyers will pay higher prices for the limited supply.
What are the government's fiscal policy options for reducing demand-pull inflation?
Contractionary fiscal policies reduce the level of spending in the economy. When governments want to reduce inflationary conditions, they will use contractionary measures, such as raising taxes or reducing government spending.