Outlined by English economist John Maynard Keynes (1883-1946), demand pull inflation describes a rise in prices triggered by an excess of demand for the available supply in the economy.
Keynes raised an important concept of an inflationary gap, which replaced the notion that inflation was caused by a rise in the money supply.
Also see: cost-push inflation, quantity theory of money
J M Keynes, How to Pay for the War (London, 1940)
How it happens
In Keynesian theory, increased employment results in increased aggregate demand (AD), which leads to further hiring by firms to increase output. Due to capacity constraints, this increase in output will eventually become so small that the price of the good will rise. At first, unemployment will go down, shifting AD1 to AD2, which increases demand (noted as “Y”) by (Y2 − Y1). This increase in demand means more workers are needed, and then AD will be shifted from AD2 to AD3, but this time much less is produced than in the previous shift, but the price level has risen from P2 to P3, a much higher increase in price than in the previous shift. This increase in price is what causes inflation in an overheating economy.
Demand-pull inflation is in contrast with cost-push inflation, when price and wage increases are being transmitted from one sector to another. However, these can be considered as different aspects of an overall inflationary process: demand-pull inflation explains how price inflation starts, and cost-push inflation demonstrates why inflation once begun is so difficult to stop.
Causes of demand-pull inflation
- There is a quick increase in consumption and investment along with extremely confident firms.
- There is a sudden increase in exports due to huge under-valuation of the currency.
- There is a lot of government spending.
- The expectation that inflation will rise often leads to a rise in inflation. Workers and firms will increase their prices to ‘catch up’ to inflation.
- There is excessive monetary growth, when there is too much money in the system chasing too few goods. The ‘price’ of a good will thus increase.
- There is a rise in population.