Two Types of Inflation on the Basis of Cause of Origin: They are Demand Pull Inflation and Cost Push Inflation.
Demand Pull Inflation
The most common cause for inflation is the pressure of ever-rising demand on a stagnant or less rapidly increasing supply of goods and services. It occurs when spending on goods and services drives up prices. Demand-pull inflation is fuelled by income, so efforts to stop it involve reducing consumer’s income or giving consumers more incentive to save than to spend.
According to the demand-pull theory, prices rise in response to an excess of aggregate demand over existing supply of goods and services. It is also called excess-demand inflation. In the excess-demand theories of inflation, excess demand means aggregate real demand for output in excess of maximum feasible, or potential, or full employment, output (at the going price level).
The demand-pull theorists point out that inflation (demand-pull) might be caused, in the first place, by an increase in the quantity of money. Demand-pull or just demand inflation may be defined as a situation where the total monetary demand persistently exceeds total supply of real goods and services at current prices, so that prices are pulled upwards by the continuous upward shift of the aggregate demand function.
Demand-pull inflation can spread across borders as well. China and India’s economic growth not only puts pressure on prices in these countries but also on prices worldwide as the demand for imports increase.
If government spending is financed by printing currency or by the central bank monetizing the debt, demand-pull inflation can become hyperinflation.
By using the aggregate demand and aggregate supply curves, the demand-pull process can be shown diagrammatically as follows:
In the above figure, the X-axis measures real output and Y-axis measures the price level. Aggregate demand curves are D,D1,and D2 whereas S curve represents Aggregate supply function , which slopes upward from left to right and at point F it becomes a vertical straight line. At this point the economy reaches at full employment level. Hence real output remains same or inelastic at this point. D curve intersect S curve at point F, where real output or income is at full employment and OP is the price level. When aggregate demand increases from D to D1 and D2, the real output or income will remain same but the price level tends to increase from OP to OP1 and further to OP2.
In short the inflationary process can be described as follows: Increasing demand increasing prices – increasing costs – increasing income – increasing demand – increasing prices – and so on.
Causes of Demand Pull Inflation
1. Increase in Public Expenditure
There may be an increase in the public expenditure (G) in excess of public revenue. This might have been made possible (or rendered necessary) through public borrowings from banks or through deficit financing, which implies an increase in the money supply.
2. Increase in Investment
There may be an increase in the autonomous investment (in firms, which is in excess of the current savings in the economy. Hence, the flow of total expenditure tends to rise, causing an excess monetary demand, leading to an upward pressure on prices.
3. Increase in MPC
There may be an increase in the marginal propensity to consume (MPC), causing an excess monetary demand. This could be due to the operation of demonstration effect and such other reasons.
4. Increasing Exports and Surplus Balance of Payments
In an open economy, an increasing surplus in the balance of payments also leads to an excess demand. Increasing exports also have an inflationary impact because there is generation of money income in the home economy due to export earnings but, simultaneously, there is reduction in the domestic supply of goods because products are exported. If an export surplus is not balanced by increased savings, or through taxation, domestic spending will be in excess of the value of domestic output, marketed at current prices.
5. Diversification of Goods
A diversion of resources from the consumption goods sector either to the capital good sector or the military sector (for producing war goods) will lead to an inflationary pressure because while the generation of income and expenditure continues, the current flow of real—output decreases on account of high gestation period involved in these sectors. Again, the opportunity cost of war goods is quite high in terms of consumption goods meant for the civilian sector. This leads to an excessive monetary demand for the goods and services against their real supply, causing the prices to move up.
In short, it is said that the demand-pull inflation could be averted through deflationary measures adopted by the monetary and fiscal authorities. Thus, passive policies are responsible for demand-pull inflation