There are many different theories that aim to determine exactly what causes inflation. One of the more commonly used arguments by Keynsian’s is known as demand pull inflation. What exactly is demand pull inflation and why is it important?
Demand Pull Inflation
John Maynard Keynes
The term “demand pull inflation” is a Keynesian economics term. According to Wikipedia,
“Keynesian economics advocates a mixed economy — predominantly private sector, but with a significant role of government and public sector — and served as the economic model during the later part of the Great Depression, World War II, and the post-war economic expansion (1945–1973), though it lost some influence following the tax surcharge in 1968 and the stagflation of the 1970s. The advent of the global financial crisis in 2008 has caused a resurgence in Keynesian thought.”The basic idea behind demand pull inflation is that strong consumer demand helps drive inflation. When there are a limited number of goods in the market, and a large demand for those goods, the prices have to increase.
For a small scale example, imagine that there were 100 people who all wanted to buy big screen TVs but only 50 were available. In this scenario, only half of the people are going to end up with what they want. Because of this, everyone is going to be willing to pay a higher amount to get access to the limited resources. The company that owns the TVs can keep jacking up the price until they find a point that customers won’t pay anymore. Those last 50 big screen TVs might sell for much more than what the first batch of TVs sold for. Keynesian economics says that there are “too many dollars chasing too few goods”.
This type of inflation occurs when the aggregate demand for goods significantly outweighs the aggregate supply in the economy. This means that it happens on a large scale. It touches on the concept of scarcity. There are only so many resources in the world that can be used to create products. If the product or good were unlimited, then people probably would not be willing to pay very much money for it. Since it is limited, there has to be a certain point at which people will pay to gain access to it. As the resource or good becomes more scarce, people will pay more for it.
Demand Pull Inflation Compared to Cost Push Inflation
The other type of inflation that Keynesian economists refer to is cost push inflation. With cost push inflation, the inflation is determined by the amount of increase in the price of the cost of goods. When the costs of goods go up, the sellers have to charge higher prices for these goods in order to make a profit.
Editor’s Note: Although there are some basic truths present in the demand pull and cost push inflation models, they do have a few inherent problems to consider. The idea of scarcity was prevalent at the time of Keynes writing in the 1930’s and formed a major basis for his thinking. Beginning in the 1970’s Keynesian Economics began to be questioned by economists like Friedrich Hayek, Milton Friedman, and Austrian School economist Ludwig von Mises.
The example of the big screen TV’s sounds reasonable until you realize that, there isn’t a limited supply of big screen TV’s because the company can always make more. If they choose to limit the supply to keep prices up a competitor will come in and produce big screen TV’s to fulfill the demand. So only in the short run would prices be higher. The problem comes in when the government steps in and creates regulations or authorizes a monopoly.
Another example would be generators immediately after a storm that wiped out power to millions of homes. In this case, Demand Pull would increase the price of the available generators but once again only for a limited time. Once the free market had an opportunity to work more generators would be shipped in from other areas and prices would return to normal.
After a storm other factors also come into play. According to the free market the best way to allocate the limited supply of generators would be to hold an auction and give the generators to the highest bidder. Thus the owner of the generators (the person with the forsight and capital to stockpile them) would maximize his profit and the consumer with the highest perceived need (the one willing to pay the most) would get the generator. Perhaps he has the largest family or the biggest freezer full of food to spoil. Or perhaps he runs a gas station and needs the generator to continue pumping gas so other people can continue to run their generators.
During these situations often “big box” home improvement stores do not raise their prices. Why? Because they value their reputation in the community over the small increase in profit they would gain on the generators. They sell the available generators at the regular price on a first come first serve basis in order to maintain good will with the community. This is also the free market at work taking the larger view.
Another example of Demand Pull Inflation in action would be the gasoline prices when all the refineries are working at 100% capacity. It takes many years to build a new refinery and because of regulatory hurdles due to environmental concerns obtaining a permit to build a modern refinery is extremely difficult and costly. So prohibitive that no new refineries have been built in the U.S. since 1976. So in effect supply is limited due to governmental regulations. This is not the result of a lack of oil or a willingness on the part of companies to supply gasoline but simply restrictive legislation preventing the free market from operating at its highest efficiency.
But what about “peak oil”? Aren’t we running out of oil? According to the Keynesian theory of Demand Pull Inflation, as oil supplies become harder to find and more costly to extract the limited supply of oil should spark demand pull inflation in the price of gasoline. But at the same time those higher prices will encourage the development of alternatives. As we have seen new “fracking” technology is making huge amounts of natural gas reserves available and “Tar Sand” is has become economically recoverable. Plus as technology improves Solar and Wind power become more economical. So as economic alternatives become available people switch to them thus reducing demand for the first product.
The more enduring problem with inflation comes from an increase in the money supply. See What is Inflation? for an explanation of the difference between price inflation (the result) and monetary inflation (the cause).
Footnote: According to American Thinker :
Despite clothing itself in the garb of egalitarianism and tolerance, the progressive movement, which draws much of its influence from Keynes, has a nasty history of fostering the perfect society through government dictum… extending the scope of societal engineering to the sphere of human birth is the next logical step. In addition to being both an anti-Semite and a pedophile, John Maynard Keynes, whose work popularized government-directed planning, was an endorser of eugenics and the centralized control of the world’s population. Keynes was the Director of the British Eugenics Society from 1937-1944.
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