Demand-pull inflation

Inflation is a general rise in the average level of prices, sustained over time.

Demand-pull inflation occurs when aggregate demand (AD) increases above the capacity of the economy to meet this demand - prices are 'pulled up' by demand, rather than being 'pushed up' by cost increases.

Causes of demand-pull inflation

Demand-pull inflation could arise from any increase in a component of aggregate demand, including:

  1. Increases in household incomes, including wages and other earnings
  2. Lower direct tax, which increases disposable income and consumption
  3. An increase in public spending - especially if it is funded by increased borrowing
  4. An increase in export demand, placing pressure on domestic firms
  5. An increase in the money supply*
  6. Lower interest rates

Each of the above will make the AD curve shift to the right.

The monetary transmission mechanism

In the case of a monetary stimulus, the monetary transmission mechanism shows the route through from interest rates to the inflation rate.

Monetary transmission mechanism

Using AD-AS analysis

AD-AS analysis is used to show the effect of an increase in aggregate demand on the price level.

Demand pull inflation

The gradient of the AS curve has an effect on the extent of inflation - the more it is elastic, the smaller the inflationary effect.

Demand pull inflation

Video on causes of inflation and policies to deal wth inflation

An increase in the money supply

It has long been noted (since the work of American economist, Irving Fisher) that excess money tends to push up prices. In his 'quantity theory of exchange' Fisher introduces a simple formulation to explain the connection between money and prices.

Fisher's equation MV=PT

Where M = the stock (supply) of money, V = the velocity of circulation of money in a given period, P = average prices, and T = the number of transactions in a given period.

We can rearrange to state that P = MV/T. If we assume that M and V are constants in the short run, then any change in the quantity of money - M, will lead to the same proportionate increase in price (P).

Costs of inflation

Why is inflation an economic problem?

Inflation costs
Cost push inflation

What causes cost ush inflation?

Cost push inflation
Monetary policy

How effective is monetary policy?

Monetary policy

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