demand pull inflation

The British economy has experienced inflation throughout the last thirty years - but the rate at which prices have been rising has not been stable. The chart below tracks the annual rate of inflation for the British economy over the last fifty years. In an open economy (i.e. a country that engages in international trade), price inflation can be caused by a number of factors. Economists divide them into two main groups, demand-pull and cost-push inflation.

Demand Pull inflation occurs when total demand for goods and services exceeds total supply. This type of inflation happens when there has been excessive growth in aggregate demand and there is an inflationary gap.

Demand-pull inflation is often monetary in origin - because the authorities allow the money supply to grow faster than the ability of the economy to supply goods and services. The phrase that is often used is that there is "too much money chasing too few goods"

An example of this was during the late 1980s with the so-called "Lawson Boom". There was a sharp rise in the demand for credit and a sharp rise in house prices. The amount of money in circulation grew at alarming rates and caused excess demand in the economy. By the autumn of 1990, retail price inflation had climbed to 10.9%. A recession was needed to bring it back down again. The chart below shows that by 1988 there was a huge inflationary gap in the economy – shown by the highly positive output gap (the difference between actual and potential GDP). This was a symptom of an economy experiencing a very high level of excess aggregate demand for goods and services

A similar though smaller inflationary gap appeared in the UK economy in 1997/98 after five years of sustained economic growth. This led the newly independent Bank of England to raise interest rates from 6% to 7.5% between May 1997 and June 1998. Fortunately the British economy responded well to the "monetary medicine" and experienced a slowdown through late 1998 and 1999. Demand-pull inflationary pressures subsided, leaving retail price inflation comfortably within the Government's chosen target range.

Demand pull inflation can be illustrated graphically using aggregate demand and aggregate supply analysis.

Aggregate supply (AS) shows the total supply of goods and services that firms are able to produce at each and every price level. At low levels of output when there is plenty of spare productive capacity, firms can easily expand output to meet increases in demand, resulting in a relatively elastic AS curve.

As the economy approaches full employment (or full capacity), labour and raw material shortages mean that it becomes more difficult for firms to expand production to meet rising demand. As a result, the AS curve becomes more inelastic. When aggregate demand (AD) increases from AD to AD1 the economy is still operating at relatively low levels of capacity. Output can expand relatively easily so firms will only implement small increases in prices from P to P1.

When aggregate demand increases from AD1 to AD2 the economy is moving towards the full employment of factors of production. Many firms choose to increase price to widen profit margins. Shortages of factor inputs mean that the firms' costs of production start to rise. Furthermore, it is likely that, as employment in the economy grows, demand for goods and services will become more inelastic. This will allow firms to pass on large price increases (P1 - P2) without any significant fall in demand.

Main causes of increased aggregate demand:

A depreciation of the exchange rate increases the price of imports and reduces the foreign price of UK exports. If consumers buy fewer imports, while foreigners buy more exports, demand in the UK economy will rise. If the economy is already at full employment, it is hard to increase output and prices are pulled upwards.

A reduction in direct or indirect taxation: If taxes are reduced consumers will have more disposable income causing demand to rise. A reduction in indirect taxes (taxes on goods and services such as VAT) will mean that a given amount of income will now buy a greater real volume of goods and services.

Rapid growth of the money supply as a consequence of increased bank and building society borrowing if interest rates are low and consumer confidence is high

Rising consumer confidence and an increase in the rate of growth of house prices - both of which would lead to an increase in total household demand for goods and services

Faster economic growth in other countries - providing a boost to UK exports overseas. Remember that export sales provide an extra flow of income and spending into the UK circular flow. Exports are counted as an injection of aggregate demand