Causes of inflation: demand-pull

Published by Patrick Mutisya · 14 days ago

IGCSE Economics 0455 – Government and the Macro‑economy: Demand‑Pull Inflation

Government and the Macro‑economy – Inflation

Objective

Explain the causes of inflation with a focus on demand‑pull inflation.

What is Demand‑Pull Inflation?

Demand‑pull inflation occurs when aggregate demand (AD) in an economy grows faster than aggregate supply (AS) at the existing price level, creating upward pressure on prices.

Key Drivers of Demand‑Pull Inflation

  • Expansionary fiscal policy – increased government spending or tax cuts raise disposable income and consumption.

  • Expansionary monetary policy – lower interest rates or quantitative easing boost borrowing and investment.

  • Rise in consumer confidence – households anticipate higher future income and spend more.

  • Export boom – higher foreign demand for domestic goods raises net exports.

  • Population growth – more people increase overall demand for goods and services.

How the AD‑AS Model Illustrates Demand‑Pull Inflation

In the short‑run AD‑AS diagram, an outward shift of the AD curve from AD₁ to AD₂ while the short‑run aggregate supply (SRAS) curve remains unchanged leads to a higher equilibrium price level (P₂) and a higher real GDP (Y₂). The rise in the price level represents demand‑pull inflation.

Suggested diagram: AD‑AS model showing AD₁ → AD₂ shift, resulting in price level rise from P₁ to P₂ (demand‑pull inflation).

Mathematical Representation

The inflation rate can be expressed as:

\$\text{Inflation Rate} = \frac{P2 - P1}{P_1} \times 100\%\$

where \$P1\$ is the initial price level and \$P2\$ is the new price level after the demand increase.

Step‑by‑Step Mechanism

  1. Government cuts taxes → households have more disposable income.

  2. Higher disposable income → increase in consumption (C).

  3. Businesses respond to higher demand by increasing investment (I) and hiring.

  4. Aggregate demand (AD = C + I + G + (X‑M)) shifts rightward.

  5. With SRAS unchanged in the short run, the equilibrium price level rises.

  6. Result: demand‑pull inflation.

Real‑World Examples

  • Post‑World War II United Kingdom – extensive government spending to rebuild the economy created strong demand pressures.

  • United States in the early 1990s – expansionary fiscal stimulus combined with low interest rates led to a brief demand‑pull inflationary episode.

Potential Consequences

  • Reduced purchasing power for consumers with fixed incomes.

  • Distortion of relative prices, potentially misallocating resources.

  • Pressure on wage negotiations, leading to a wage‑price spiral if not managed.

Policy Responses to Demand‑Pull Inflation

Policy ToolActionExpected Effect on AD
Fiscal ContractionIncrease taxes or reduce government spendingShifts AD leftward, easing price pressures
Monetary TighteningRaise interest rates or sell government securitiesReduces borrowing and consumption, shifting AD leftward
Supply‑Side MeasuresImprove productivity (e.g., training, infrastructure)Shift SRAS rightward, allowing higher output without price rise

Summary

Demand‑pull inflation is caused by an excess of aggregate demand over the economy’s short‑run productive capacity. It is typically triggered by expansionary fiscal or monetary policies, higher consumer confidence, or external demand surges. Understanding the AD‑AS framework helps explain why price levels rise and guides policymakers in selecting appropriate counter‑inflationary measures.