Inflation

Exploring the Basics of Demand-Pull Inflation

The effect of supply and demand on each other helps establish the prices of products/services in an economy. Not enough supply or an overabundance in demand can send prices for goods surging.

In fact, demand-pull inflation occurs as the aggregate demand in the economy exceeds aggregate supply, thereby pulling prices up.

Demand-Pull Inflation Explained

Demand-pull inflation is when the demand for products/services increases at a much quicker pace than their supply.

It is a phenomenon where the economy’s aggregate demand outpaces aggregate supply. They either declines or stays the same in this situation, causing prices for products/services to climb.

This period of inflation has taken place in the real estate sector during the 2007-2009 Great Recession and in the gaming and medical equipment businesses during the pandemic.

Distinguishing Demand-Pull Inflation from Cost-Push Inflation

Simply put, demand-pull inflation is due to demand being higher than supply. On the other hand, cost-push inflation is due to the supply of products/services decreasing while their demand remains unchanged.

Cost-push inflation occurs when the economy’s aggregate supply declines first because of reasons like unexpected natural disasters, higher labor prices, or supply chain issues.

Such developments in the economy can prompt companies to raise their prices to pay for higher output costs, resulting in cost-push inflation.

Common Causes of Demand-Pull Inflation

Some of the common factors behind demand-pull inflation are:

A Growing Economy

A growing economy with a low unemployment rate usually increases consumer income and spending. It then leads aggregate demand to become higher than aggregate supply.

Lack of Supply

Demand-pull inflation also stems from businesses’ inability to push their supply high enough to meet demand.

Demand goes up as consumers earn more income and spend more money. If the productive capacity is lower than demand and firms see that it is beating supply, they will need to keep up with demand by raising prices.

Strong demand for raw materials and labor spreads throughout an economy, and it may take a while for output to match the demand.

More Money Being Printed

Economists have described demand-pull inflation as a situation where there are “too many dollars chasing too few goods.”

Sometimes, the Federal Reserve will print more money than it should due to heavy pressures in the economy. That, in turn, drives liquidity, which could boost aggregate demand for products/services.

Inflation Expectations

If there is potential for a surge in near-term inflation, consumers may purchase more goods right now before the expected price surge occurs. That allows them to avoid spending more money later on possibly higher-priced products.

Such a move, however, increases demand, resulting in demand-pull inflation.

Government Spending

Government spending can strengthen demand for particular products.

Fiscal policies such as tax cuts on specific goods or stimulus in an economic slump can affect how much consumers spend as it provides them with more income to pay for products/services. If that exceeds supply, it can cause demand-pull inflation.

Key Inflation Measures

Economists rely on three key measures to assess inflation in the US: the Consumer Price Index (CPI), the Producer Price Index (PPI), and the Personal Consumption Expenditures Price Index (PCE).

CPI

A widely used inflation measure, the CPI determines the prices consumers usually pay for products/services over time.

The CPI tracks the overall price change based on a fixed basket of goods that follows eight major groups: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services.

PPI

The PPI represents the average price change paid to domestic producers for their output. Higher prices for raw materials or labor can impact supply, which can then cause demand-pull inflation.

PCE

The PCE measures the prices that companies receive for products/services. A preferred inflation indicator by the Fed, the PCE tracks a more extensive range of products/services being bought, unlike the CPI, which follows a fixed basket of goods.

Inflation-Proofing Your Investments

Inflation can eventually reduce the purchasing power of money kept in cash or a savings account. While it’s discouraging to see your money gradually lose value, there are certain asset classes you should check out, as they have the potential to beat inflation.

Some of these investment options include:

Stocks

While individual stocks tend to decline, opting for a diversified market index fund can provide the long-term inflation hedge and returns you may be looking for.

Bonds

Bonds are another investment option you can consider if you plan to build wealth without having to worry too much about inflation weighing down your profit-making in the long run.

However, bonds’ potential returns are usually lower than stocks. Although they’re a good choice if you prefer to avoid risks as an investor and are about to or already retired. That’s because bonds and bond funds can provide more stable and consistent returns than stocks when you hold them to maturity.

Treasury Inflation-Protected Securities (TIPS)

TIPS is a type of US bond designed mainly to minimize the long-term, heavy impact of inflation. As inflation increases or decreases, TIPS can adjust its principal through changes in the CPI. Once a TIPS reaches maturity, you receive the initial or adjusted principal, depending on which is higher.

Hedging Inflation with Gold

Investors who own gold can gain some form of protection or hedge against inflation as the US dollar falls. However, it’s not as good as bonds or TIPS in terms of providing security and better rates when prices for products/services are rising.

Moreover, gold prices are not only influenced by the broader economy. Factors such as the global foreign exchange (forex) rates, central banks’ policy decisions, and unpredictability in demand and supply can also affect the price of the precious yellow metal over time.

Another thing you should keep in mind is that when you put money into gold, you will need a secured storage place for it, which you have to pay for.

In addition, you need to consider the possibility that you will have to deal with more long-term capital tax gains than stocks and bonds if you sell your gold after holding on to it for more than one year.

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