What is Demand Inflation?

Ken Black

Demand inflation, sometimes called demand-pull inflation, results when there is an excess of demand and no ability, or very little ability, to increase supply. In some ways, it is simple supply-and-demand economics -- when the demand goes up, the price goes up to bring the supply and demand back into equilibrium. However, in some cases supply can be increased. This is generally not the case with demand inflation.

Prices can rise during demand inflation, which occurs when people seek to buy a product or products but supply is limited.
Prices can rise during demand inflation, which occurs when people seek to buy a product or products but supply is limited.

Demand inflation is the opposite of cost-push inflation, the latter of which is caused by a decrease in supply. In some ways, if inflation is going to take place, demand inflation is the more desirable scenario. Demand inflation can be one of the signs of a healthy economy.

A product's value increases when demand outpaces production.
A product's value increases when demand outpaces production.

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The idea behind the theory of demand inflation is simple. It simply postulates that as demand rises, a company will naturally hire more people to fill that demand, as long as business is good. However, at some point it will no longer matter how many people are employed. Production capacity will peak, or at least get to a point where the increase in capacity is so small that it makes very little difference in meeting demand. This will naturally lead to price increases, thus causing demand inflation.

Once a business has pushed its production capacity to a certain level, it is extremely difficult for it to achieve further increases. For example, a manufacturing assembly line can only go so fast. Once the line is running multiple shifts around the clock, there may be little else a company can do.

However, in cases where production is pushed to the limit, companies do have a few options. One is to increase the number of production lines. This may be a very expensive option that usually requires building a new facility or retrofitting existing facilities. This is expensive and companies may be unwilling to do this without a good guarantee the demand will stay at an increased level.

For companies who do choose to increase production by increasing facilities and production lines, it is not a quick fix and demand inflation will likely continue until implementation. Building these facilities takes planning and a great deal of time. In all likelihood, the time from initial concepts to full production in a new, or even retrofitted facility, will likely take at least 12 months. Therefore, unless other forces act to decrease the demand, demand inflation will likely continue for a significant period of time.

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