When aggregate demand for goods and services exceeds aggregate supply of output which is produced by fully employing the given resources of an economy, excess demand is said to occur. This excess demand leads to the rise in general price level i.e. inflation in the economy. Before full employment of resource is reached, any rise in aggregate demand will cause aggregate supply of output to rise.
Rise in production of output is followed by more employment and income. The rise in the general price is followed by rising employment and income. But after full employment resources in the economy, the productive resources are exhausted thus any rise in demand will not raise supply of output. Production of output remains constant but due to constant rise in aggregate demand price level will tend to rise.
This rise in price levels is called true inflation according to Keynes. In such a case rise in aggregate demand is the cause of inflation. This type of inflation is called demand-pull inflation. Thus demand-pull inflation is caused by an increase in the aggregate effective demand’ for goods and services in the economy. The effective demand increases due to increased money incomes of the factors of production consequent upon increased investment in the economy.
Demand pull inflation or excess demand inflation occurs when aggregate demand for goods and services is greater than the available supply of these goods and services at the existing price level. Excess demand means aggregate real demand for output in excess of maximum feasible, or potential or full employment output at the going price level.
Thus demand-pull inflation may be defined as a situation where the aggregate demand exceeds the economy’s ability to supply the goods and services at the current prices, so that the prices are pulled upward by the upward shift of demand function.
Keynes in his booklet “How to pay for the war” published during the Second World War explained inflation in terms of excess demand for goods relative to the aggregate supply of their output.
His notion of inflationary gap which he put forward in his booklet represented excess of aggregate demand over full-employment output. This inflationary gap, according to him, leads to the rise in prices. Thus Keynes explained inflation in terms of demand pull forces.
Therefore the theory of demand-pull inflation is associated with the name of Keynes. Demand pull inflation can be illustrated with aggregate demand and supply curves. In the fig given below aggregate demand and supply of output are measured along the OX-axis and general price level along Oy-axis.
SS is the aggregate supply curve which is horizontal (SA portion) until nearly full employment is reached. It becomes vertical after full employment is reached i.e. after point B corresponding to full employment output OM3. If aggregate demand curve is DD, output is OM. If aggregate demand curve increases to the level D then output increases to OMp without any increase in the price level (OS).
If aggregate demand curve increases to D2D2, price level will increase to OP and output to OM2. If the demand curve further increases to D3D3, output reaches the full employment level OM3 $and the price level rises to OPr After full employment output, any further increase in the aggregate demand (D4D4) will lead to price rise without increasing output. This as long as the economy is beyond the flat range of aggregate supply curve, increase in demand will pull the prices up i.e. create demand pull- inflation.