Demand-Pull Inflation: Causes and Examples

As you may have learned in microeconomics, prices of anything that can be purchased are theoretically determined by the relationship between aggregate demand and aggregate supply. When demand for a particular product is greater (or increases faster) than supply and the relationship isn’t in equilibrium (a state of balance), then prices (as measured by inflation) increase.

One effect is that the Federal Reserve, which has a target inflation rate of 2%, will raise interest rates to slow down economic activity. By making borrowing money more expensive, purchasing demand is reduced and theoretically should mitigate demand-pull inflation. However, this is a hit-or-miss strategy and there’s a possibility that interest rates rise too quickly or too high, resulting in more of a slowdown in the economy (such as rising unemployment) than hoped for.

Besides Social Security, retirees very often have to pay for their expenses by withdrawing from retirement accounts that aren’t growing faster than what they’re taking out. On top of that, their investments probably don’t increase as much as the rate of inflation. As a result, they may not have as much buying power as they anticipated when they were planning their retirement. It’s easier than you think to underestimate your anticipated living expenses in retirement because of not fully accounting for inflation.

Specific examples of demand-pull inflation include rising house prices. When mortgage rates are low, monthly interest payments are reduced and real estate is seen as more affordable. This leads to more consumers interested in purchasing homes with the supply of existing homes being fixed and not enough new homes being built or not constructed fast enough. This greater demand leads to higher home prices.

Many examples also occurred during the pandemic. One was when medical experts were recommending people frequently wash their hands. Since it was inconvenient (and unrealistic) for most to wash their hands often, hand sanitizers became popular as a substitute. Although they existed before the pandemic, the encouraged use of hand sanitizers resulted in a large increase in demand with sales rising by 73% in February 2020, leading to higher prices.

When prices are expected to grow at an increasing rate in the future, consumers may buy more in the present when prices are relatively less (compared to the anticipated forthcoming higher prices). Also, if the Federal Reserve expands the money supply to boost the economy, consumers will have more disposable income and will generally spend it rather than save it.

But demand isn’t confined to just individual consumers. When the government (whose spending makes up about 25% of the Gross Domestic Product (GDP)) increases its spending, that also results in increased demand which may not be accompanied by an increase in supply to mitigate it.

Several factors can contribute to demand-pull inflation. One is the Federal Reserve setting low interest rates (so that borrowing is cheaper) which can cause consumer spending to increase more than producers can increase production. An increase in real wages (wages increasing faster than the rate of inflation) can also cause consumer spending to increase.

For those currently contributing to retirement plans, the goal is to save a certain amount in today’s dollars for retirement expenses. But the purchasing power of the amount saved will be less after the effects of inflation reduce what that amount can pay for in your retirement. As a result, what’s been saved for retirement can be underestimated if inflation isn’t fully accounted for and current savings may need to be increased.

Although Social Security benefits have cost of living adjustments (COLA), inflation can still decrease the effects of COLA. For example, Medicare Part B premiums, which historically have increased more than COLA, are deducted from Social Security benefits.

Inflation in any form erodes your purchasing power since you’re able to buy less as prices increase. What you can purchase for a dollar today is more than what you can buy for a dollar tomorrow if the prices of goods and services increase. Demand-pull inflation can cause prices to increase more than wages, resulting in real wages (income adjusted for inflation) declining. As a result, you end up spending more on goods and services.

Cost-push inflation can occur when the demand for a good or service remains static (or decreases) while the price increases (which could occur from a supply shortage). As such, the price increase comes from the supply side, usually in the form of rising production prices. An example of this was supply chain interruptions during the pandemic when consumers were still purchasing products but manufacturing facilities weren’t operating at full capacity, often because of workplace shutdowns. This led to higher costs of production and raw materials.

Both an increase in demand and a decrease in supply can lead to inflation. Demand-pull inflation is caused by consumers wanting to buy more of a service or good without a corresponding increase in supply. Cost-push inflation is caused by an increase in supply costs which are forwarded on to the consumer. If the demand of consumers doesn’t decrease, prices will continue to rise.

Inflation tends to affect asset classes in different ways. For example, commodities and real estate tend to do better since they both benefit directly from higher prices. Although these may not be thought of as part of an investment portfolio, that’s why it’s important to have well-diversified investments that include asset classes such as these to help insulate you against the adverse effects of rising prices.

When saving for retirement, make sure to account for inflation. If you don’t, you could end up underestimating your retirement expenses and how much you need to save for them. If you’re trying to match your savings with expenses, then you may have to save more than you originally thought. But the earlier you realize this, the less you’ll have to increase your savings.

Also, keep in mind that inflation is a moving target. The causes of inflation change from time to time so you’ll have to continue to monitor its impact on your savings.

A financial advisor can help determine if you’re saving enough for retirement. Advisors have experience modeling the future effects of inflation and how your spending may change in retirement. This can give you a better idea of how much you may need to set aside now so you won’t be caught short when saving for retirement expenses.

Don’t let underestimating the effects of inflation leave a nasty surprise in retirement! You can have peace of mind by thinking about this well ahead of time. Adjusting your savings now can bring many benefits in your retirement, leaving you to enjoy that stage of life to its fullest.

If you have any concerns about the effects of demand-pull inflation and how it could affect your plans for retirement savings, consult a financial advisor. With available tools and experience, they can help answer your questions and alleviate your worries.