Demand-Pull Inflation
What is Demand-Pull Inflation?
Demand-pull inflation is a rise in the general price level caused by an increase in aggregate demand that outpaces what the economy can produce.
Demand-pull inflation occurs when aggregate demand exceeds the available supply of goods and services, causing prices to rise. This type of inflation is often caused by an increase in consumer spending, investment, or government expenditure. As demand increases, businesses respond by raising their prices, leading to inflation. Demand-pull inflation can be controlled by reducing aggregate demand through monetary or fiscal policy.
Demand-Pull Inflation: a worked example
An economy sits at its potential output of $800 billion with a price level index of 100. Government spending rises by $50 billion and the marginal propensity to consume is 0.8, so the spending multiplier is 1 divided by (1 minus 0.8), which equals 5. The horizontal shift in aggregate demand is $50 billion times 5, or $250 billion. Because the economy is already at capacity, short-run aggregate supply is steep, and the new equilibrium lands at real GDP of $840 billion with a price level index of 112. Inflation is (112 minus 100) divided by 100, times 100, or 12 percent. Output rose only $40 billion even though aggregate demand shifted $250 billion to the right. The rest of the shift was absorbed by the rising price level instead of by extra production, which is the signature of demand-pull inflation near full employment.
The mistake students make with demand-pull inflation
The most common error is treating the multiplier result as the new level of real GDP. A student computes a $250 billion aggregate demand shift and writes that output rises $250 billion, which would only be true if the price level never moved. The multiplier measures the horizontal distance the AD curve travels, not where it intersects an upward sloping short-run aggregate supply curve. Once prices rise, the economy slides up along SRAS and captures a smaller output gain. State the shift and the new equilibrium as two separate numbers.
Demand-Pull Inflation questions
What causes demand-pull inflation?
Demand-pull inflation begins with any increase in a component of aggregate demand when the economy is near or beyond potential output: a consumption boom, a surge in business investment, higher government spending, a tax cut that lifts disposable income, stronger export demand, or an expansion of the money supply that lowers interest rates. Spending outruns the economy's ability to produce, buyers bid against each other for a limited quantity of goods, and the price level climbs.
Can demand-pull inflation happen during a recession?
Demand-pull pressure is weak in a deep recession because the economy has idle factories and unemployed workers, so the short-run aggregate supply curve is relatively flat. A rightward shift in aggregate demand there raises real output a lot and the price level only slightly. The same shift near full employment, where SRAS is steep, produces mostly inflation and little extra output. Where the economy sits relative to potential determines how much of a demand increase turns into prices.
How do policymakers stop demand-pull inflation?
Policymakers shift aggregate demand back to the left. Contractionary fiscal policy cuts government spending or raises taxes, reducing disposable income and consumption. Contractionary monetary policy raises the policy interest rate or sells bonds, shrinking the money supply and discouraging borrowing for investment and durable goods. Because a demand shift moves the price level and real output in the same direction, cooling demand-pull inflation also slows growth and raises unemployment, which is the cost policymakers weigh.
This is the live AD/AS Model sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime. Read our privacy policy.
Keep track of what you have studied
A free EconLearn account adds progress tracking, your quiz history, and achievements. Studying here is free either way, and there is nothing to pay for as a student.
Create a free accountAlready have one? Sign in
Last updated