Demand-Pull Inflation

Idea

Demand-pull inflation arises when aggregate demand in an economy increases faster than aggregate supply, raising the general price level with little or no increase in real output. It is the inflation of an economy that is pulling against its capacity ceiling.

Mechanism

When aggregate demand (AD) rises without a matching rise in productive capacity, firms try to expand output to meet it. If the economy is already near full employment, most factors of production are already employed, so firms bid against one another for scarce resources. This competition for resources raises unit costs of production; to protect their profit margins, producers charge higher prices. The result is a rise in the general price level with output unable to expand much beyond full capacity.

Diagram

Demand-pull inflation: aggregate demand shifts right from AD₀ to AD₁ near full employment, on the steep (near-vertical) range of LRAS. The general price level rises from P₀ to P₁ while output rises only from Y₀ to the full-employment level Y_f, beyond which it cannot expand.

Considerations

The size of the price effect depends on where on the aggregate-supply range the economy sits. With ample spare capacity (the horizontal range), a rise in AD raises output with little price effect — this is actual growth rather than inflation. The closer the economy is to full employment, the steeper the range and the more an AD increase shows up as higher prices rather than higher output. Demand-pull inflation is therefore the characteristic risk of an economy whose actual growth has outrun its potential growth.