Previous Year Question

Demand-pull inflation arises when aggregate demand for goods and services increases faster than the economy’s available productive capacity or aggregate supply.

Aggregate demand is commonly represented as:

Where:

• C= Household Consumption

• I= Private Investment

• G= Government Expenditure

• X - M= Net Exports

When the growth of these components causes total demand to exceed the economy’s productive capacity, more money begins chasing a limited quantity of goods and services. Prices consequently rise.

Statement 1: Expansionary policies — correct

Expansionary policies seek to raise economic activity and aggregate demand. They may include both expansionary fiscal policy and expansionary monetary policy.

Such measures include:

• increasing government expenditure;

• reducing tax rates;

• reducing policy interest rates;

• increasing liquidity in the banking system; and

• improving the availability of credit.

These measures can raise disposable income, consumption, borrowing and investment. If the economy is already operating close to its productive capacity, additional demand may increase prices more than output. Therefore, Statement 1 is correct.

Statement 2: Fiscal stimulus — correct

Under a fiscal stimulus, the Government increases expenditure, reduces taxes or adopts both measures.

For example, if the Government spends an additional ₹1 lakh crore on infrastructure, the income of contractors, workers and input suppliers increases. They spend a portion of this additional income on consumption. Through the multiplier effect, aggregate demand may increase by more than the initial government expenditure.

If the resulting demand exceeds available supply, it can generate demand-pull inflation. Therefore, Statement 2 is correct.

Statement 3: Inflation-indexing wages — incorrect

Under inflation-indexed wages, employee wages are adjusted according to an inflation index to protect their real purchasing power.

For example, if the monthly wage is ₹30,000 and indexation produces a 6% increase, the revised wage will be:

This may support consumption demand to some extent. However, wage indexation is not primarily classified as an original cause of demand-pull inflation. It can transmit existing inflation into wages and increase firms’ production costs, thereby sustaining cost-push inflation or a wage-price spiral.

Therefore, Statement 3 is not included under the classification used in the question.

Statement 4: Higher purchasing power — correct

When the purchasing power of households increases, they can demand more goods and services.

Purchasing power may increase because of:

• higher incomes or wages;

• reductions in taxes;

• government cash transfers;

• cheaper and more easily available credit; and

• higher employment.

If production does not increase proportionately with consumption, the gap between demand and supply pushes prices upward. Higher purchasing power can therefore increase demand-pull inflation.

Statement 5: Rising interest rates — incorrect

When interest rates rise:

• housing and vehicle loans become more expensive;

• demand for consumer credit declines;

• the financing cost of business investment increases;

• saving becomes relatively more attractive; and

• growth in consumption and investment slows.

Rising interest rates consequently tend to reduce aggregate demand and demand-pull inflation rather than increase them.

Interest Rate↑ ⇒ Borrowing↓ ⇒ Consumption/Investment↓ ⇒ Aggregate Demand↓

Therefore, Statements 1, 2 and 4 are correct. Hence, the correct answer is (a).