According to classicals, the key factor is the money supply because in accordance with the quantity theory of money only an increase in the money supply is capable of raising the general price level. Demand-pull inflation can be a good thing for the economy in the short term, but it is something that needs to be carefully monitored. As demand increases, it can lead to higher prices and inflationary pressures that might eventually cripple an economy. It’s important to understand the causes of demand-pull inflation to be able to spot it when it happens. During the Great Depression, a decreasing aggregate demand pulled the price level lower.

When new technologies are introduced, demand for the products and services that support them often goes up. For example, when a new iPhone is released there becomes an immediate demand for a case that will protect that phone. When iPhones were fairly new, the number of suppliers making these cases was few, which meant the demand often outweighed the supply and people paid more than they might be willing to pay today. There are ways to counter both cost-push inflation and demand-pull inflation, which is through the implementation of different policies. We can take an example of a small country named Staples with a landmass of just 100 square miles.

By the time the Federal Reserve recognized the true extent of the demand-pull inflation bubble that had developed, the crash that followed was so severe that it threatened to destroy the global financial system. Explore the significance of currency appreciation and depreciation, their effect on a country’s economy, and learn what governments do to counteract the effects. Here, the domestic currency is worth less than the foreign currency.

23.1 in which aggregate demand and aggregate supply are measured along the X-axis and general price level along the Y-axis. Curve AS represents the aggregate supply which rises upward in the beginning but when full-employment level of aggregate supply OYF is reached, aggregate supply curve AS takes a vertical shape. If other sectors are not prepared to acquiesce in this increase in the share of output used by any one sector, all of the sectors together will be trying to get more of the national output than production has provided. When aggregate demand for all purposes— consumption, investment and government, expenditure—exceeds the supply of goods at current prices, there is a rise in prices. Aggregate supply is the total volume of goods and services produced by an economy at a given price level. When the aggregate supply of goods and services decreases because of an increase in production costs, it results in cost-push inflation.

Demand Destruction

Finally, higher wages increase the disposable income of employees, leading to a rise in consumer spending. Now assume the economy is nearing the peak of a business cycle. The economy nears its natural level of production where all resources are being used in an efficient manner. Increases in the aggregate demand diagram of demand pull inflation are very inflationary and have a minimal impact on production levels. Note that the increase in the price level from PL1 to PL2 is much greater on Graph 3, and the increase in the output from RGDP1 to RGDP2 is less than on Graph 2 because the intersection with the SRAS is on a steeper part of the curve.

However, to understand demand-pull inflation, it is helpful to begin at the microeconomic level. You notice that more people are interested in your services as the economy recovers from a recent recession. You cannot keep up with the demand for your services, so you increase your price and increase the number of hours you babysit. This is illustrated by an increase in the demand for your services in Graph 1.

Disadvantages of Demand-Pull Inflation

The inference is an increase in the AD when an economy is near the peak of its business cycle is much more inflationary than when it is beginning its recovery from a recession. Let us suppose that the full-employment level of output remains fixed at Y0. General equilibrium is established at Y0 and i0 with price level p0. Let’s take a look at how cost-push inflation works using this simple price-quantity graph. The graph below shows the level of output that can be achieved at each price level. As production costs increase, aggregate supply decreases from AS1 to AS2 (given production is at full capacity), causing an increase in the price level from P1 to P2.

Prices increase modestly from PL1 to PL2 and production increases from RGDP1 to RGDP2. To counter demand pull inflation, governments, and central banks would have to implement a tight monetary and fiscal policy. Examples include increasing the interest rate or lowering government spending or raising taxes. An increase in the interest rate would make consumers spend less on durable goods and housing.

Demand Pull Inflation Example

Keynes explained that inflation arises when there occurs an inflationary gap in the economy which comes to exist when aggregate demand exceeds aggregate supply at full employment level of output. Thus, the rise in price level is accompanied by the appearance of unemployment. Further increase in money wage will bring further upward shifts in the SS curves (e.g., S2S). Each increase in money wage rate leads to a higher price level, lower output and higher unemployment. If left to increases, such increases in the money wage rate cannot continue indefinitely as the worsening unemployment that follows each such increase may be expected to restrain the Unions’ demands for ever higher money wage rates.

• This effect can be seen more clearly in the Keynesian Aggregate Demand curve.
• Demand-pull inflation can be illustrated with aggregate demand and supply curves.
• The Keynesian approach points out that there is a gap in inflation in the economy as overall spending continues to rise once the economy reaches full employment equilibrium.

The decline in growth rate was due to an aging population and decaying infrastructure. The problem could only be solved by improving the skills of the workforce and by investing in the infrastructure. By employing an expansionary monetary policy, the excess money increased demand, without increasing the capacity. The Figure 32.5 shows that pure-demand-inflation theorists tend to assume that at some income level Y0 in the Figure corresponding to full-employment, the aggregate supply function becomes completely inelastic, as drawn.

Inflation – Policies to Control Inflation

This drives the demand for Chipped’s microchip up and in turn, causes them to need to increase prices in order to keep up with the new demand. This could cause the original widgets to increase in price again because of this demand because Widgetized is paying these increased costs due to the demand they actually caused. Demand-pull inflation is inflation caused by an increase in an economy’s aggregate demand. This theory shows that as a result of the struggle between oppressed groups to demand a share of the national income, prices are pushing up. Further expansion of the demand curve will only increase the price level to P2 and P3.

This is because after the level of full employment, supply of output cannot be increased. When aggregate demand curve is AD1 the equilibrium is at less than full- employment level where price level OP1 is determined. Now, if the aggregate demand increases to AD2, price level rises to OP2 due to the emergence excess of demand at price level OP1. In the demand-pull inflation graph below I have illustrated what happens when aggregate demand increases beyond a level that the economy can sustain in the long run. It inevitably causes the price level to rise as firms struggle to supply enough goods and services to meet the increased demand.

His notion of the inflationary gap which he put forward in his booklet represented excess of aggregate demand over full-employment output. The ordinary functioning of an economy should result in distributing and spending income in such a manner that aggregate demand for output is equivalent to the cost of producing total output including profits and taxes. At times, however, the government, the entrepreneurs or the households may attempt to secure a larger part of output than would thus accrue to them. This represents a situation where the basic factor at work is the increase in aggregate demand for output either from the government or the entrepreneurs or the households.

They further argue that the real national income or aggregate output (i.e., Y in the demand for money function stated above) remains stable at full employment level in the long run due to the flexibility of wages. If the total claims on output exceed the available supply of output, prices will rise. The rise in prices provides the necessary mechanism whereby the real resources being currently used by inactive sectors are reduced so that they should be used by the more active sectors. It is important to note that Keynes in his booklet How to pay for the War published during the Second World War explained inflation in terms of excess demand for goods relative to the aggregate supply of their output.

Cost-Push Inflation

The price level at which each possible level of output will be supplied increases proportionally with the increase in the money wage rate. With aggregate demand of D0, the result of the higher money wage rate and the resultant upward shift in SS function from S0S to S1S is a rise in the price level from P0 to P1 and a fall in the output level from Y0 to Y1 (which results in unemployment). When interest rates rise to a high enough level, the demand for money will become totally inelastic with respect to the rate of interest. At this point there are no more speculative balances to be had, attempts to borrow funds either will be frustrated or, because of the resultant increase in interest rates, will cause the abandonment of other ventures. But since he aggregate supply curves is yet sloping upward, increase in aggregate demand from AD2, to AD3 has -used the increase in output from OY2 to OYF.

The increasing rate of inflation in 2022 occurred due to a combination of cost-push and demand-pull factors. The excess demand came primarily from the huge fiscal stimulus checks sent out during the pandemic lockdowns, first by the Trump administration, and then by the Biden administration. Additionally, the loose monetary policy and extensive packages of quantitative easing boosted the money-supply from 2008 right up to 2022, with huge inflation in real estate prices as well as stocks and shares. Note that real gross domestic product increases on Graphs 2 and 3.

Shifts in the aggregate demand curve are caused by changes in consumer spending, government spending, businesses investing, and net exports. Increases in these variables cause the aggregate demand curve to increase and have an inflationary impact on the economy. The magnitude of the demand-pull inflation depends on the slope of the short-run aggregate supply curve (SRAS). But they emphasise that when the growth in money supply is greater than the growth in output, the result is excess demand for goods and services which causes rise in prices or demand-pull inflation. This is the start of demand-pull inflation, and it happens because there is insufficient spare capacity in the economy to be able to raise production enough to satisfy all the extra demand.

Top 3 Theories of Inflation (With Diagram)

Escalator clauses provide for monetary correction on account of the facts of inflation, a measure also known as indexing. Under it as the inflation increases, the real income of labour is protected by equivalent wage increases. Another variant of cost-push inflation is administrative inflation, which can occur during recession, recovery or shortages or simultaneously with demand-pull inflation. According to an important variant of the cost-push theory, sectoral shifts in demand are the main causes of the inflationary process.

• Central banks may use monetary policy, such as raising interest rates, to try to slow down demand and reduce inflationary pressures.
• Their view is that the general price is determined by the total demand for and total supply of goods just as the price of any good is determined by the forces of demand and supply for it.
• Finally, if a government reduces taxes, households are left with more disposable income in their pockets.

According to the figure, the price level rises from P1 to P3 as the aggregate supply continues to increase. In 2019 Sri Lanka went through an economic crisis because of increased taxes. The government had put restrictions or taxes on certain products, increasing the prices—as a result, leading to higher levels of inflation.