Demand-pull inflation is a form of inflation that arises when the demand for goods and services is greater than their supply.
Demand depends on households' income, level of private investments and government expenditures. Supply of goods and services, on the other hand, depends on the economy's production capacity, which is limited at least in the short-run. Demand-pull inflation occurs when the excess money available with consumers increases demand beyond the maximum capacity of the producers. Expansionary monetary policy is the main reason for demand-pull inflation.
Concordia is a small country with land mass of just 100 square kilometers. It has historically achieved an impressive growth rate. However, the country has ageing workforce and deteriorating infrastructure. In early 2012, inflation rate was 3%. New data suggested that the country was falling behind on its growth target. It was taken negatively by the holders of sovereign bonds and the government was worried.
The central bank of the country, however, was eager to maintain the growth rate. In a speech, the chairman of the central bank said that the central bank would do 'whatever it takes' to achieve the growth rate. Soon it embarked upon an aggressive expansionary monetary policy. It decreased discount rate thereby pushing interest rates down, purchased government bonds, decreased required reserve ratios and let the commercial banks loosen credit standards. It resulted in massive increase in consumption. People were particularly interested in purchasing new homes and cars. The country's required 2,000 cars per month and 1,000 housing units per quarter. However, it could only produce 1,200 cars per month and 800 housing units per quarter.
The Senate's finance committee is due to receive a briefing from Seweryn Szwarocki, the finance minister. Seweryn knows that the first question the committee is going to ask would be: what went wrong? You are a consultant working with the ministry of finance. Draft a response for the minster.
Concordia is in the mess due to demand-push inflation. The central bank embarked upon the expansionary monetary policy without understanding the whole situation. The decline in growth rate was due to ageing population and deteriorating infrastructure. The problem could only be solved by allowing immigration of skilled young workforce and by investing in the infrastructure. Without solving the fundamental problem, the central bank just pumped in fresh money into the economy. More money increased demand. However, the country could not increase its capacity. Demand outstripped capacity and resulted in demand-pull inflation.
Written by Obaidullah Jan, ACA, CFA