What is demand-driven inflation?
Demand-driven inflation is the upward pressure on prices that follows a shortage of supply. Economists describe it as “too many dollars chasing too few goods”.
Demand-driven inflation is a principle of Keynesian economics that describes the effects of an imbalance in aggregate supply and demand. When aggregate demand in an economy far outweighs aggregate supply, prices rise.
It is the most common cause of inflation.
Demand pull inflation
Understanding demand-driven inflation
The term demand-driven inflation generally describes a widespread phenomenon. In other words, when consumer demand exceeds the available supply of many types of consumer goods, demand-driven inflation sets in, forcing an overall increase in the cost of living.
Key points to remember
- When demand exceeds supply, higher prices result. It is demand-driven inflation.
- Low unemployment is generally good, but it can lead to inflation as more people have more disposable income.
- Higher public spending is also good for the economy, but it can lead to a shortage of some goods and inflation will follow.
In Keynesian economic theory, an increase in employment leads to an increase in the overall demand for consumer goods. In response to demand, companies are hiring more people to increase production. The more companies hire people, the more employment increases. Finally, the demand for consumer goods exceeds the ability of manufacturers to supply them.
Causes of demand-driven inflation
Demand-driven inflation has five causes:
- A growing economy. When consumers feel confident, they are spending more and going into debt. This leads to a steady increase in demand, which means higher prices.
- Asset inflation. A sudden increase in exports leads to an undervaluation of the currencies concerned.
- Government spending. When the government spends more freely, prices go up.
- Inflation expectations. Companies may raise prices in anticipation of inflation in the near future.
- More money in the system. An expansion of the money supply with too few goods to buy drives up prices.
Demand-driven inflation vs. Cost inflation
Cost-push inflation occurs when money is transferred from one economic sector to another. More specifically, an increase in production costs such as raw materials and wages is inevitably passed on to consumers in the form of higher prices for finished products.
In the good times, companies are hiring more. But, ultimately, increased consumer demand could exceed production capacity, causing inflation.
Demand and cost increases are evolving in much the same way, but they operate on a different aspect of the system. Demand-driven inflation shows the causes of rising prices. Cost-driven inflation shows how difficult it is to stop inflation once started.
Example of demand-driven inflation
Let’s say the economy is in a boom and the unemployment rate drops to a new low. Interest rates are also low. The federal government, which is seeking to phase out more fuel-efficient cars, is introducing a special tax credit for buyers of fuel-efficient cars. The major auto companies are delighted, even if they did not foresee such a confluence of optimistic factors at the same time.
The demand for many car models is going through the roof, but the manufacturers literally can’t make them fast enough. The prices of the most popular models are increasing and deals are rare. The result is an increase in the average price of a new car.
But it is not only cars that are affected. Since almost everyone is in paid employment and borrowing rates are low, consumer spending on many goods increases beyond the available supply.
This is demand driven inflation.