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What is Demand-Pull Inflation?

Definition: Demand-pull inflation is an increase in price of goods or services as a result of the aggregate demand for these goods or services being greater than the aggregate supply thus eroding the purchasing power of the currency. In this sense, the economic demand is pulling the purchasing power of the currency down and causing inflation.

What Does Demand-Pull Inflation Mean?

What is the definition of demand-pull inflation? This type of inflation occurs when the overall economy is growing faster than the long-term growth rate. Increased consumer demand causes the general price level to rise and the aggregate demand for goods and services increases, thereby outpacing the aggregate supply.

Besides the increase in consumer spending, the aggregate demand may increase as a result of a rise in exports, expectations about inflation or a strong monetary growth. These factors lead to higher inflation as the real output increases, whereas unemployment decreases because the greater demand forces firms to employ more workers.

Let’s look at an example.

Example

Demand-pull inflation is often the result of technological innovation. For instance, in 2006, the growing demand for financial products such as credit default swaps (CDS) and asset-backed securities (ABS) led to demand-pull inflation because the demand outweighed supply.

Credit default swaps and asset-backed securities offered insurance against default on mortgages. The insurance they provide increased the demand for these innovative financial products and consumers were purchasing asset-backed securities to monitor the prices of mortgages on the stock market. As demand for both CDS and ABS grew higher, the price of their underlying assets, which were the houses, increased as well. Ultimately, the demand for houses outpaced supply. Given that the supply of houses reacts slowly to increases in demand, a prolonged period of a greater demand led to higher housing prices.

On the other hand, the buildup in prices in the housing market had a substantial supply-side effect that started in 2002. At that time, housing prices were about 25% above the average rate, thus creating an oversupply of houses. To fuel the housing market, the Federal Reserve suggested that homeowners should buy adjustable-rate mortgages (ARMs).

After a prolonged period of price appreciation, housing prices returned to their “normal” rates, which were their long-term average rates of appreciation. Ultimately, supply and demand were in equilibrium.

Summary Definition

Define Demand-Pull Inflation: Demand pull inflation is when the demand for a product or service increases faster than the companies can supply thus increasing the price of the goods or services.

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