5 Causes of Demand-Pull Inflation

Demand-pull inflation is when aggregate demand for a good or service outstrips aggregate supply. It starts with an increase in consumer demand. Typically, sellers meet such an increase with more supply. But when additional supply is unavailable, sellers raise their prices. That results in demand-pull inflation.

It is the most common cause of inflation. The other reason, cost-push inflation, is rarer.

It starts with a decrease in total supply or an increase in the cost of that supply costs. Suppliers raise prices because they know consumers will pay it. That situation is called inelastic demand.

Five Causes of Demand-Pull Inflation

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

The second is the expectation of inflation. Federal Reserve Chairman Ben Bernanke explained it this way. Once people expect inflation, they will buy things now to avoid higher future prices.

 That increases demand, which then creates demand-pull inflation. Once expectation of inflation sets in, it's hard to eradicate. For example, businesses expected higher interest rates and inflation in the 1970s. That created galloping inflation. At the same time, President Nixon imposed wage-price controls which slowed economic growth.

The combination created stagflation.

Bernanke was the first U.S. Federal Reserve chairman to set an inflation target. It's 2 percent. That's because a healthy economy grows between 2 - 3 percent. The target uses the core inflation rate. It eliminates volatile food and energy costs. 

The third cause is over-expansion of the money supply. That's when there is too much money chasing too few goods. That typically occurs when the government prints too much money. It usually does this to pay off its debt. It's the primary driver of hyperinflation. It can also occur if the Federal Reserve puts too much credit into the banking system. ​

The third cause is discretionary fiscal policy. Government spending drives up demand. For example, military spending raises prices for military equipment. When the government lowers taxes, it also drives demand. Consumers have more discretionary income to spend on goods and services. When that increases faster than supply, it creates inflation. 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.

The fourth 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. That's 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.

The fifth reason is technological innovation. A company that creates a new technology owns the market until other companies figure out how to copy it. People will demand products with technologies that create a real improvement in their daily lives. The new technology also creates a cachet for those who must own the latest gadget.  For example, Tesla's electric sports car was a technological breakthrough.

It used new advanced motors, power trains and battery packs. It is so successful that it sells these parts to other auto companies. 

Examples of Demand-Pull Inflation

Another example of technological innovation was in financial products. Credit default swaps were a new type of insurance product. They guaranteed against a default on mortgages and other kinds of loans. This coverage 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. Banks' demand for mortgages to underwrite the derivatives drove housing price inflation until 2006. That's when supply finally caught up with demand and home prices started to fall. It helped create the financial crisis of 2008.

The Federal Reserve overexpanded the money supply at the same time. It lowered the fed funds rate to 1 percent in 2003 to combat the recession. It remained there for a year. Inflation rose to 3.3 percent. Housing prices rose more, creating a bubble.

Deregulation allowed banks to push mortgages onto everyone. When people could borrow for almost nothing, and needed no money down, it made no sense to rent. With low interest rates, homeowners used their homes as ATMs. They spent their home equity on medical care, housing and consumer goods. But inflation only showed up in home prices and health care. The price of everything else didn't rise, thanks to China. It kept its currency, the yuan, pegged to the dollar. That artificially lowered the prices of its exports to the United States.

After the 2008 financial crisis, asset inflation occurred in gold and oil prices. Deflation occurred in housing prices and personal income. Demand-pull inflation continued in gold prices until they reached a record. That was $1,895 an ounce on September 5, 2011. Demand for gold rose as investors worried about 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. (Source: "The Economic Lowdown," St. Louis Federal Reserve. "Demand-Pull Inflation," The Intelligent Economist.)