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Demand-pull inflation is a type of inflation caused by an increase in aggregate demand. In a model of aggregate demand-aggregate supply, it occurs when the aggregate demand curve shifts to the right.
In such situations, too much money chases few goods and services. Demand is higher than what the economy can provide. Thus, the prices of products and services increase (or when actual real GDP is above its potential output).
Rising prices force workers to renegotiate higher wages. Inflation erodes the purchasing power of their nominal wages on goods and services. Therefore, an increase in wages is needed to offset the rise in living costs.
Causes of demand-pull inflation
Causes of increased aggregate demand can stem from an increase in government spending or export demand. Low-interest rates also drive up household consumption and business investment, increasing aggregate demand. Likewise, a reduction in corporate and personal tax rates also has the same effect as a decrease in interest rates.
Other factors are exchange rate depreciation, increased household wealth, expectations of improved household income and business profits, and strong global economic growth.
An increase in wages can trigger a wage-price spiral. An increase in wages increases the cost of production. To maintain profits, producers increase selling prices to offset rising labor costs. As a result, the prices of goods rose higher.
Workers renegotiate higher wages. Production costs increase higher further and force producers to increase selling prices. The inflation rate rises again.
The spiral process continues and can endanger the economy. To reduce the pressure caused by the wage-price spiral, the government tighten economic policies, either through tight fiscal or tight monetary policies.