Inflation can arise from both demand and supply factors, significantly impacting price levels in an economy. Demand-pull inflation occurs when increased demand for goods and services outpaces supply, leading to higher prices. This phenomenon is characterized by "too much money chasing too few goods," where consumers are willing to spend more, but the available supply remains constant. In a typical supply and demand graph, this situation is illustrated by a rightward shift of the demand curve, indicating an increase in demand.
When demand increases, the equilibrium price and quantity also rise. However, if supply cannot adjust to meet this new demand—due to constraints in production or resources—the quantity supplied remains at its original level. This results in a higher equilibrium price, as consumers are willing to pay more for the limited goods available. The original equilibrium price, denoted as \( P^* \), shifts to a higher price level, referred to as \( P_H \), reflecting the inflationary pressure caused by demand-pull factors.
In contrast, cost-push inflation occurs when the costs of production increase, leading to a decrease in supply. This type of inflation pushes prices upward as producers pass on higher costs to consumers. Understanding these two types of inflation is crucial for analyzing economic conditions and the factors influencing price stability.