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What Is Demand-Pull Inflation?

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Higher Gas Prices Spur Rise In Consumer Price Index
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Question: What Is Demand-Pull Inflation?
Demand-pull inflation is, by far, the most common cause of inflation. The other two are cost-push inflation and expansion of the money supply.
Answer: Demand-pull inflation occurs when demand for a good or service increases so much that it outstrips supply. As demand increases, sellers start selling out of the product, and frustrate potential customers. Their next step would be to produce more. However, if supply is constrained, their next step would be to raise prices, creating inflation. Therefore, for an increase in demand to cause inflation, there must be a supply constraint, otherwise supply would simply rise to meet demand.

What Creates Demand-Pull Inflation?

There are five sets of circumstances that can lead to demand-pull inflation. The first is a growing economy. When families feel confident that they will get raises and better jobs, that their homes and other investments will increase in value, and that the government is doing the right thing in guiding the economy, they will spend more instead of saving. They will also borrow more, either with auto or home loans, or credit cards. If they don't borrow too much, this is actually a healthy cause of inflation. It creates gradual and steady price increases.

Expectation of inflation is a second reason for demand-pull inflation. This was pointed out by Federal Reserve Chairman Ben Bernanke. He said that, once people expect inflation, they will buy things now before prices go up further in the future. This increases demand, which then created demand-pull inflation. Once expectation of inflation sets in, it is very difficult to eradicate. That's why the Fed's most important mandate is to fight inflation. Bernanke is the first U.S. Federal Reserve Chairman to set an inflation target to make sure the market knows he won't let inflation rise. The inflation target is based on the core inflation rate, which eliminates volatile food and energy costs. A healthy economy can sustain a core inflation rate of 2%, which is Bernanke's target.

Discretionary fiscal policy is a third creator of demand-pull inflation. As the government spends more in any particular segment of the economy, it drives up demand. For example, military spending raises prices for military equipment.

If the government lower taxes, consumer have more discretionary income to spend on goods and services. If it increases demand above supply, inflation will result. For example, tax breaks for mortgage interest rates increased demand for housing. Government sponsorship of mortgage guarantors Fannie Mae and Freddie Mac also stimulated demand. Although there were many other reasons for the housing bubble, they wouldn't have been as attractive without government fiscal policies. (Source: The St. Louis Federal Reserve, The Economic Lowdown; The Intelligent Economist, Demand-Pull Inflation)

A fourth reason for demand-pull inflation is a strong brand, itself created by marketing. Marketing can create high demand for certain products, a form of asset inflation. A great example is Apple products, including the iPod, iPad and iPhone. Prices for these goods are higher than comparable products because the consumer feels Apple understands their needs, including emotional ones. There is a certain cachet to owning an Apple product, and that allows Apple to charge higher prices.

A fifth reason for demand-pull inflation is technological innovation. The iPhone was a technological breakthrough, allowing Apple to charge higher prices for a new type of cell phone. Even when other competitors created similar products, Apple added innovations, allowing them to keep prices from dropping.

Examples of Demand-Pull Inflation

Another example of technological innovation was in financial products. Credit default swaps were a new type of insurance that guaranteed against default of mortgages and other types of loans. This insurance generated higher demand for another innovation, asset-backed securities. These allowed securities that tracked the prices of mortgages to be sold on a secondary market, much like stocks. These securities could not have been created without another technological innovation, super-computers. They process the value of these complex derivatives. As demand for the securities rose, so did the price of the underlying assets, houses. When inflation only hits one asset category, it's known as asset inflation.

The Federal Reserve didn't take steps to stop this asset inflation because it was restricted to housing, and hadn't spread into other areas of the economy. This was the greatest factor creating demand-pull inflation in housing until 2006, when supply finally caught up with demand and home prices started to fall. To understand more, see What Is the Global Financial Crisis of 2008?

In the aftermath of the 2008 financial crisis, there was inflation in two asset classes, gold and oil prices, with deflation in two others -- housing prices and personal income. Demand-pull inflation continued in gold prices until they reached an all-time record of $1,895 an ounce on September 5, 2011. Demand for gold rose as investors grew worried about the economic fall-out from the eurozone crisis and the U.S. debt default crisis. As a result, they bought gold as a hedge against either a dollar or euro collapse. Article updated March 12, 2012

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