Q. Level of aggregate demand in economy?
Demand-pull inflation takes place when there is an increase in level of aggregate demand in economy. Aggregate demand comprises five components that are defined in following equation:
AD = consumption + investment + government spending + (exports - imports)
When there is an increase in one of the components - investment, consumption, government spending or exports - the level of economic activity in economy will rise and real national output will surge. This will be signified on a diagram as AD shifting to right. Though as aggregate demand increases there will be greater pressure on resources and firms supplying services and goods may face the problem of excess demand specifically if production capacity is limited. This will consequence in businesses increasing prices and/or employing more overtime workers less efficiently to satisfy demand. The higher prices will feed in the inflation indices RPI and CPI as the price level rises at the same time as GDP growth takes place (providing there is spare capacity in economy).
Demand-pull inflation has been caused mostly by the growth in consumption spending, caused by rising levels of disposable income that in turn stems from a combination of increased employment, lower interest rates, tax cuts, easy credit as well as increased household confidence.