Demand-pull inflation occurs whenaggregate demand in an economy is more thanaggregate supply. It involvesinflation rising asreal gross domestic product rises andunemployment falls, as the economy moves along thePhillips curve. This is commonly described as "too much money chasing too fewgoods".[1] More accurately, it should be described as involving "too much money spent chasing too few goods", since only money that is spent on goods and services can cause inflation. This would not be expected to happen, unless the economy is already at afull employment level. It is the opposite ofcost-push inflation.
InKeynesian theory, increased employment results in increased aggregate demand (AD), which leads to further hiring by firms to increase output. Due to capacity constraints, this increase in output will eventually become so small that the price of the good will rise.At first, unemployment will go down, shifting AD1 to AD2, which increases demand (noted as "Y") by (Y2 − Y1). This increase in demand means more workers are needed, and then AD will be shifted from AD2 to AD3, but this time much less is produced than in the previous shift, but the price level has risen from P2 to P3, a much higher increase in price than in the previous shift. This increase in price is what causes inflation in an overheating economy.
Demand-pull inflation is in contrast withcost-push inflation, when price and wage increases are being transmitted from one sector to another. However, these can be considered as different aspects of an overall inflationary process—demand-pull inflation explains how price inflation starts, and cost-push inflation demonstrates why inflation once begun is so difficult to stop.[2]
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