What is Demand Pull Inflation?

Today’s blog might come off as an Economics class for you, so beware! For here lie the secrets that work the economies of countries. 

Demand and Supply are some of the most basic and first few terms that are taught to anyone entering the world of business. Do you remember the things that were once taught to you? 

That, demand should be equal to supply in any given market. When demand is equal to supply, equilibrium is achieved. When demand exceeds supply, there is excess demand, and prices rise. When supply exceeds demand, there is excess supply, and prices start to fall. 

This we have learnt very well by now. What we have not learned is how this excess demand and supply affects our economy on a larger scale. What are these terms called? How is it corrected? 

Before we begin, take a moment and answer honestly, do you know what causes inflation? 

What causes Inflation?

The rate at which the prices of goods and services rise in an economy is called Inflation. It basically means that your purchasing power decreases over time. This, in theory, everybody knows.

But, what does it mean for a common man like you and me? 

A week ago, I had ₹10, and I could buy 4 bananas from it. But due to inflation, today, the fruit seller would only give me 3 bananas for ₹10. The money I spend on bananas remain the same, but quantity decreases. This is what is called a decrease in purchasing power of the currency. 

Printing more fiat currency makes the current currency less valuable, and thus, for every unit of goods that we purchase, we have to pay a price higher compared to what it was before. 

Inflation inherently has got a reputation of being bad. But is that really the case?

A good bacteria in curd helps in its formation, while a bad bacteria in our body may cause food poisoning. Similarly, inflation can be good, and inflation can be bad. 

You must wonder how and why is inflation good, right? Let’s break it down.

In an economy, higher expenditure by consumers fuels economic growth. So, for economic growth, it is essential that consumer demand be forced to go up, which ultimately would force consumption to go up as well.

This is how it happens. When more currency is printed, the money supply in an economy will rise, and theoretically, there will be inflation. But since more money is in the flow, people will tend to spend more. When this money is spent in an economy where the resources are underutilized, it will force demand to go up. More demand would mean the production of more goods, thereby increasing consumption. With me so far?

There are essentially three types of inflation - demand-pull inflation, cost-push inflation and built-in inflation. 

Today, we shall learn about what demand-pull inflation is, how it impacts the economy and how is this controlled. 

Demand-pull Inflation

Demand-pull inflation occurs when in an economy, the demand for goods and services increase, typically triggered by overall economic growth, technological innovations, or a rising inflation rate. As there is more demand for goods and services, production houses try to keep up with the demand, and in the meantime, the prices start to rise.

The economists like to call this condition as “too many dollars chasing too few goods”. 

When aggregate demand and aggregate supply are imbalanced and demand is greater than supply in an economy, demand-pull inflation sets in. For this phenomenon to occur, there has to be a limit set on the increased supply that would cause the prices to go up. This pushes the overall cost of living to go up as well. It shows that the economy is strong, and the employment level is likely to go up as well. 

Let’s take a look at a few things, among many, that triggers demand-pull inflation.

Causes of Demand-pull Inflation

There are various causes of Demand-pull Inflation:

A Prospering Economy:

With advancements in technology, proper utilization of resources, favourable laws and adequate allocation of human capital, an economy usually shows steady growth. In a growing economy, consumers trust the system and spend more. This increases the demand and leads to higher prices. 

Increased Export Demand:

An increase in export demands increase the flow of foreign exchange in a particular country. It also creates new jobs opportunities, and the income of the working population rises. An unexpected rise in exports pushes all of this to go on a faster pace, and the value of currency gets reduced in the foreign exchange. This causes the prices to rise. 

Increased Government Spending:

When the government increase its purchases, the cost of production of goods are likely to increase. This inturn, increases the prices of final goods and inflation sets in.

Rising Inflation Rate: 

When prices of goods and services rise a little bit, people start buying even more as they believe that the prices are going to rise further. This increases the overall demand and supply falls short. 

Technological Innovations: 

When a new technology is introduced in the market, the demand for the new product increases rapidly. The demand for services that support these also rise. The demand outweighs the supply yet again and prices rise. 

More Money in the System: 

Increased money supply in an economy where demand is increasing and supply falls short even when resources are functioning at an optimal level, leads to inflation.  

Pros and cons of Demand-pull Inflation

Demand-pull inflation can prompt the economy and is not bad news after all. Let us take a look at the good and bad aspects of it. 

Pros of Demand-pull Inflation

• Increased wages - When demand-pull inflation sets in, the wages of the people who are in lower side of the reimbursement scale are re-evaluated and to keep up with rising prices, their wages are increased as well.

• Creation of jobs - As demand for goods and services increases, more jobs are created to create a higher supply of the same.

• Prompts the economy - The expectation of price increase in future, creates a higher demand in the present. People start buying more and consuming more. This pushes the economy to grow for a short period of time.

Cons of Demand-pull Inflation

• Increased prices - Well, this is an obvious point that inflation means increased prices and lower purchasing power of consumers.  

• Increased inflationary pressure - While there are short-term perks of demand-pull inflation since there is job creation and better wages, but for the long term, this could lead to higher interest rates and value depreciation of the currency of the economy.

• Depreciation in the value of the currency - Since the prices keep on increasing and fluctuating, it would be difficult to evaluate the correct value of currency so it leads to decreased value compared to other currencies. 

The Bottom Line

The good bacteria and bad bacteria example extends to our economy as well. Demand-pull inflation could be good for the economy for a short period as it stirs it up which is very much required every once in a while. But if kept unchecked, the prices keep on rising and may cross the ‘safe-level’. Thus, it is important to spot demand-pull inflation when it happens and keep a check on it. 

That’s it for today’s article. Until we meet again.