UPSC Prelims 2021 Q12: Causes of Demand-Pull Inflation — Explained
With reference to Indian economy, demand-pull inflation can be caused/increased by which of the following?
1. Expansionary policies
2. Fiscal stimulus
3. Inflation-indexing wages
4. Higher purchasing power
5. Rising interest rates
Select the correct answer using the code given below.
- 1, 2 and 4 only
- 3, 4 and 5 only
- 1, 2, 3 and 5 only
- 1, 2, 3, 4 and 5
Answer: (a) 1, 2 and 4 only
Statement-wise explanation
- 1: correct — Expansionary policies make money cheaper or more plentiful. Examples are cutting the repo rate, buying government securities through open market operations, or cutting taxes and raising government spending. More money and cheaper credit raise spending by households, firms and the government, so aggregate demand goes up. When demand grows faster than the economy can produce, prices rise. That is demand-pull inflation.
- 2: correct — A fiscal stimulus is a deliberate rise in government spending, or a cut in taxes, made to lift aggregate demand. Government spending (G) is a direct part of aggregate demand (C + I + G + NX). Tax cuts leave people with more disposable income, which raises consumption (C). If output cannot keep up, the extra demand pulls prices up.
- 3: incorrect — Indexing wages to inflation raises wages automatically whenever prices rise. Wages are a production cost, so firms raise prices to cover them. That raises the price index again, which pushes wages up again: the wage-price spiral. Economists class this as a cost-push (supply-side) cause, not demand-pull. Indexing protects real income that would otherwise fall; it does not add new demand. The official key treats it as cost-push.
- 4: correct — Purchasing power rises when incomes go up, credit gets easier or savings are released. People with more purchasing power demand more goods and services. If supply does not rise as fast, sellers can charge more. This is the textbook demand-pull case: 'too much money chasing too few goods'.
- 5: incorrect — Rising interest rates do the opposite. They make borrowing for homes, cars, business investment and consumer credit more expensive, and they make saving more rewarding. Spending falls, so aggregate demand falls. This is why the RBI's Monetary Policy Committee raises the repo rate to control inflation. Higher rates are contractionary and reduce demand-pull pressure.
How to eliminate
Statement 5 is the anchor. Every aspirant knows that RBI raises interest rates to fight inflation, so rising rates cannot cause demand-pull inflation. Removing statement 5 leaves only the option with 1, 2 and 4. You do not need to judge statement 3 at all. Statements 1, 2 and 4 are also clearly about raising spending, which is the definition of demand-pull. The one fact worth remembering for similar questions: wage indexation and the wage-price spiral are standard examples of cost-push inflation. To classify any cause, ask whether it raises spending (demand-pull) or raises the cost of producing (cost-push).
Know more
Inflation by cause
Inflation is a sustained rise in the general price level. Economists group its causes by which side of the market moves.
| Type | What happens | Typical triggers | Policy remedy |
|---|---|---|---|
| Demand-pull | Aggregate demand runs ahead of supply (a positive output gap) | Expansionary monetary policy, fiscal stimulus, deficit financing, rising incomes, credit boom, export surge | Raise policy rates, reduce liquidity, fiscal consolidation |
| Cost-push | Production costs rise and firms pass them on | Crude oil and input price shocks, wage indexation and wage-price spiral, rupee depreciation (imported inflation), higher indirect taxes | Supply-side fixes, buffer stocks, tax and import adjustments |
| Structural | Persistent supply bottlenecks | Weak farm storage, logistics and market gaps; monsoon dependence | Investment in supply chains and productivity |
| Expectations-driven | People expect higher prices and act on it | Bargaining for higher wages, pre-emptive price hikes | Credible inflation targeting |
Why the classification matters in India. A large share of India's CPI basket is food, so much of Indian inflation comes from supply shocks such as a poor monsoon or vegetable price spikes. Monetary policy works mainly through demand, so a rate hike cannot quickly fix a supply shock. It works by cooling demand and anchoring expectations. Under the flexible inflation targeting framework, the RBI's Monetary Policy Committee aims for 4% CPI inflation with a band of 2% to 6%.
Two traps.
- Indexation does not create demand-pull. It preserves purchasing power, while its main effect runs through costs.
- Expansionary fiscal policy, such as a deficit financed by printing money, is usually demand-pull. A hike in indirect taxes such as GST or excise duty is cost-push.
In the news
In 2020–21 the government announced large COVID-19 relief and stimulus packages, and the RBI kept the repo rate at a record low with an accommodative stance. Meanwhile CPI inflation stayed above the 6% upper tolerance limit for much of 2020. Whether stimulus would fuel demand-pull inflation was a live debate when this paper was set.
NCERT Concepts to Revise
- Demand-pull inflation: The question asks which listed factors fit this definition of aggregate demand exceeding supply.
- Cost-push inflation: The other main category of inflation. Each statement must be sorted between demand-side and cost-side causes.
- Fiscal stimulus: Statement 2 names this policy. Knowing how it acts on aggregate demand settles it.
- Expansionary monetary policy: Statement 1 refers to expansionary policies. This entry explains the monetary version and its effect on credit and spending.
- Contractionary monetary policy: Statement 5 describes rising interest rates. This entry explains what that policy does to demand.
- Inflation expectations: Wage indexation in statement 3 is linked to expectations and the wage-price spiral. This helps place it on the right side.