Inflation: Demand Pull Inflation

Inflation is a fall in the market value or purchasing power of money. It is the opposite of deflation. It refers to a continuous increase in the aggregate price level of goods and services rather than just a one-time increase in it. In other words, inflation means rise in price level or fall in the value of money. Inflation is simply the increase in the general price level in sufficiently a long period. In
some context the term inflation is used to refer to an increase in the money supply, although this concept is also often referred to as monetary expansion. Due to the causes of inverse relationship between general price level and value of money, inflation is continuous decrease in value or the purchasing power of money.

Inflation results from an increase in the amount of circulating currency beyond the needs of trade; an oversupply of currency is created. In the past, inflation was often due to a large influx of bullion, such as took place in Europe after the discovery of America and at the end of 19th century. In modern times, wars are the most common cause of inflation, as government borrowing, the increase in money supply, and a diminished supply of consumer goods, increase demand relative to supply and thereby cause rising price. The economists have defined inflation in many ways. Some of the definitions have been presented here.

According to Edward Shapiro, “Inflation is a persistent and appreciable rise in the general level of prices.” In the words of Gardner Ackley, “Inflation is defined as a persistent and appreciable rise in the general level of prices. This clearly makes inflation a process rising prices not higher prices.” In the words of Coulbourn, “Inflation is too much money charging too few goods”. According to Sir RG Hawtrey, “Inflation is the issue of too much currency.” Similarly, in the words of Prof. Samuelson, “Inflation occurs when the general level of prices and costs is rising.”

Demand Pull Inflation

Demand pull inflation occurs when there is an excess demand over the available supplies at existing prices. Excess demand means aggregate real demand for output in excess of maximum feasible, or potential, or full employment output. Excess demand is generated by forces operating on the demand side of the commodity market.

As a result of increase in demand, the aggregate demand function shifts upwards to the right (supply function remaining constant). In this case, rise in price is caused exclusively by the increase in demand as could be seen in the figure.
In the figure, OU shows the full-employment level of real output. Beyond OU, rise in prices does not, result in increase in the real output. As the demand for real output increases from D1 to D2 and D3 to D4, the prices level also rises from P1 to P2, P3 and P4 respectively.

Causes of Demand Pull Inflation

Demand-pull inflation is caused by the following factors.
i) Excess demand
Prof. Keynes has explained the effect of excess demand on prices through his notion of ‘inflationary gap’. Inflationary gap may be defined as an excess of aggregate demand for goods over their aggregate supply measured at constant prices.

ii) Increase in money supply
Monetarists held excess increase in the quantity of money responsible for inflation. According to the quantity theory of money, at a given level of national income (potential as well as actual) the general price level (P) rises in the same proportion as increase in the quantity of money (M), the velocity of money being held constant. In a static economy, M is policy-determined; therefore, the rate of inflation also becomes policy-determined.

In a dynamic economy, the real demand for money grows over time and the national income also grows over time. Apparently, the rate of growth of real demand for money will be equal to the rate of growth of the national income. However, excess increase in the stock of money will lead to increase in prices. Excess supply of money is nothing but the excess demand for output that causes inflation.

iii) Disposable income
It refers to the income payments to factors after personal taxes have been paid. An increase in disposable income results in increased purchased power with the people. There is increasing pressure on the demand for goods and services, as a result, prices tend to rise.

iv) Increase in business outlays
During the prosperity phase of business activities, increase in business outlays or capital expansion take on a speculative character. New equipment and plans are often financed by speculative borrowings. Most of business outlay finds their way into the income stream via dividends, wages and other factor payments. These business outlays are inflationary in character.

v) Increase in foreign demand
Increase in the export demand for domestic goods and services also lead to inflation. This is particularly true of the economies which maintain considerable inflationary pressure on domestic areas of shortages which may be a focal point of spreading inflation.

vi) Increase in government expenditure
There may be an increase in the government expenditure of government revenue. This might have been made possible through government borrowings from banks or through deficit financing, which implies an increase in the money supply.

vii) Reduction of taxation
If government reduces taxes, households are left with more disposable income in their pockets. This leads to increase consumer spending, thus increasing aggregate demand and eventually causing demand pull inflation.

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