Demand Pull Inflation

Inflation occurs when the demand for a commodity continually outstrips its supply. So due to a sustained increase in demand over the supply, the result is what we call demand pull inflation. That is to say that the prices of the commodities are driven up because of the increase in the requirement for those products.

The law of demand states that when the need for a commodity is higher than its supply in the market, then the price of that commodity increases. The price increase is because since there are too many buyers for that commodity, the only way to decide who gets to buy the limited amount of products available is the price.

Hence we can see that this law has an important bearing on the increase in the prices of goods and thus leads to inflation. But surely, this is too small a situation to trigger off national or regional inflation? The term inflation is clearly not attached to increase in the prices of one or two randomly selected goods in one economy?

Yes, surely the given law has a decidedly lower impact on inflation, but it sets the tone for what is to come. Demand pull inflation is an important part of Keynesian economics and further explanation for the same was given by John Maynard Keynes.

Now, let us take the aforementioned example forward, where the demand comfortably outstrips the supply for a commodity. To address the rising need and to tap the opportunity of generating higher sales and therefore, greater revenues, the business will employ more and more people.

The business will also purchase more and more raw materials to help increase the supply. Now, with more people productively employed, more people will have more money in their hands. The raw material provider too will have access to more funds as his own sales increase.

This means that there is suddenly more money in the market, and the purchasing power of the people increases. With the increase in purchasing power, it is normal human tendency to go out and purchase items which they could previously not afford, thus increasing those prices further.

Consider your own case. If your salary increases, you will no doubt ditch the humble offerings of roadside fast food chains and opt for the classier restaurants. It's your purchasing power which tempts you to buy more and thus drives up the requirement for the product.

So the effect of increased purchasing power has a multiplying effect on demand and hence, this increase in the requirement does not stay localized and becomes a national phenomenon, causing an effect on the entire economy.

So while this inflation often causes a bigger hole in your pockets, a certain level of it (around 2-3%) is necessary. Inflation is an important indicator of the increase in the demand and purchasing power of the people, and hence, in capitalist economies, it is considered to be a good thing.