Demand Pull Inflation

What is inflation? In the simplest terms one can say that inflation is an increase in the prices of goods and services in an economy, which occurs due to reduction of the value of the national currency. Basically, when there is inflation in an economy, you can purchase fewer goods and services in one dollar than what you could previously. But inflation is not just a one off increase in the prices of one particular commodity, but a general and sustained increase in the prices right from the increase in the cost of production to the cost of living. There are two basic types of inflation in the economy classified according to what the cause of inflation is - cost push and demand pull inflation.

Definition

Inflation occurs when the demand for a commodity continually outstrips supply. So due to a sustained increase in demand over the supply, the result is what we call demand pull inflation. That is to say that the prices of the commodities are driven up because of the increase in the demand for those products.

Causes

What has demand got to do with an increase in the prices, you ask? Let me take you back to the old law of demand. The law of demand states that when the demand for a commodity is higher than its supply, then the price of that commodity increases. The price increase is because since there are too many buyers for that commodity, the only way to decide who gets to buy the limited amount of products available is the price. So, since the product is available only to the highest bidder, the price of the commodity increases. Hence we can see that the law of demand - the connection between demand and supply and price - has an important bearing on the increase in the prices of goods and thus leads to inflation.

But surely, this is too small a situation to trigger off national or regional inflation? The term inflation is clearly not attached to increase in the prices of one or two randomly selected goods in one economy?

Yes, surely the law stated above has a decidedly lower impact on inflation, but it sets the tone for what is to come. Demand pull inflation is an important part of Keynesian economics and further explanation for the same was given by John Maynard Keynes.

Now, let us take the above example forward, where the demand comfortably outstrips the supply for a commodity. To address the rising supply and to tap the opportunity of generating higher sales and therefore greater revenues, the business will employ more and more people. The business will also purchase more and more raw materials to help increase the sales. Now, with more people productively employed, more people will have more money in their hands. The raw material provider too will have access to more funds as his own sales increase. This means that there is suddenly more money in the market, and the purchasing power of the people increases. With the increase in purchasing power, it is a normal human tendency to go out and purchase items which they could previously not afford, thus driving those prices further again. Consider your own case. If your salary increases, you will no doubt ditch the humble offerings of roadside fast food chains and opt for the classier destinations. It's your purchasing power which tempts you to buy more and thus driving up the demand. So the effect of increased purchasing power has a multiplying effect on the demand and hence the increase in demand does not stay localized and becomes a national phenomenon, causing an effect on the entire economy.

So while this inflation often causes a bigger hole in your pockets, a certain level of inflation (around the 2 - 3% mark) is always said to be a good thing. Inflation is an important indicator of the increase in the demand and purchasing power of the people and hence in capitalist economies, is considered to be a good thing.