AS Macro Revision: Demand Pull Inflation

Demand pull inflation occurs when aggregate demand and output is growing at an unsustainable rate leading to increased pressure on scarce resources and a positive output gap.

When there is excess demand in the economy, producers are able to raise their prices and achieve bigger profit margins because they know that demand is running ahead of supply.

Typically, demand-pull inflation becomes a threat when an economy has experienced a strong boom with GDP rising faster than the long run underlying growth of potential GDP. Demand-pull inflation is likely when there is full employment of resources and aggregate demand is increasing at a time when SRAS is inelastic. Demand-pull inflation is essentially ‘too much money chasing too few goods.’

The main causes of demand-pull inflation

1/ A depreciation of the exchange rate which increases the price of imports and reduces the foreign price of UK exports. If consumers buy fewer imports, while exports grow, AD in will rise – and there may be a multiplier effect on the level of demand and output

2/ Higher demand from a fiscal stimulus e.g. via a reduction in direct or indirect taxation or higher government spending. If direct taxes are reduced, consumers will have more disposable income causing demand to rise. Higher government spending and increased government borrowing feeds through directly into extra demand in the circular flow

3/ A large monetary stimulus to the economy: A fall in interest rates may stimulate too much demand – for example in raising demand for loans or in causing sharp rise in house price inflation. Monetarist economists believe that inflation is caused by “too much money chasing too few goods” and that governments can lose control of inflation if they allow the financial system to expand the money supply too quickly.

4/ Faster economic growth in other countries – providing a boost to UK exports overseas. Export sales provide an extra flow of income and spending into the UK circular flow – so what is happening to the economic cycles of other countries definitely affects the UK

Demand pull inflation is clearly less of a problem for the UK at present as we are still in the early stages of an economic recovery and there is plenty of spare capacity (i.e. short run aggregate supply can be drawn as elastic). The main inflation threats come from cost-push (supply-side) causes.