Association of Chartered Certified Accountants (ACCA) Certification Practice Test

What is the primary cause of "demand-pull" inflation?

1. An increase in production costs

2. Decrease in aggregate supply

3. An increase in aggregate demand exceeding production capacity

4. Reduction in consumer pricing

The correct answer is: An increase in aggregate demand exceeding production capacity

Demand-pull inflation occurs when the overall demand for goods and services in an economy outpaces the supply. This situation typically arises when there is an increase in aggregate demand, which might be driven by factors such as consumer spending, government expenditure, or investment. When demand exceeds production capacity, businesses cannot keep up with this heightened demand, resulting in upward pressure on prices as they raise prices to balance the demand with the limited supply available. In this scenario, the surge in demand creates a situation in which consumers are willing to pay more for goods and services, which leads to increased prices, hence the term "demand-pull." The other options provided do not capture the essence of demand-pull inflation: an increase in production costs relates more to cost-push inflation, while a decrease in aggregate supply would not directly address the demand component. A reduction in consumer pricing would generally be associated with deflationary pressures, contrasting the inflation focus of this question.