Inflation and Bubbles and Tulips: Crash Course Economics #7

Summary

This script from Crash Course Economics explores the concept of inflation, explaining its impact on purchasing power and how it affects wages. It introduces the consumer price index (CPI) as a tool to measure inflation and adjust for it when comparing historical prices. The video also discusses various causes of inflation, including demand-pull and cost-push factors, and examines economic bubbles, like the housing market bubble, as examples of how prices can soar due to speculation and then crash.

Takeaways

• 📈 Inflation is the general rise in prices over time, which can erode the purchasing power of money.
• 💼 A raise in wages might not be a real increase if inflation outpaces it, reducing the actual purchasing power.
• 🛒 Purchasing power is the measure of how much 'stuff' one can buy with their money, affected by price levels.
• 📊 Economists use the Consumer Price Index (CPI) to measure inflation by comparing the cost of a basket of goods over time.
• 🎬 Adjusting for inflation is crucial when comparing historical financial figures, such as movie box office sales.
• 🌐 CPI accounts for changes in the cost of a standard basket of goods but doesn't adjust for new products or quality improvements.
• 📉 Deflation, a fall in prices, is the opposite of inflation and has been observed in countries like Japan.
• 🇻🇪 Venezuela's economic mismanagement and reliance on oil have led to high inflation and a struggling economy.
• 🏠 Housing prices can rise due to speculation and bubbles, not just supply and demand, as seen in the early 2000s.
• 🌷 Historical bubbles, like the Dutch tulip mania, demonstrate the dangers of irrational exuberance in markets.
• 💡 Understanding inflation is practical for negotiating wages and making informed financial decisions.

Q & A

What is the concept of inflation as discussed in the script?

Inflation is the general increase in prices over time. It erodes purchasing power, meaning that the same amount of money buys fewer goods and services as time goes on.

How does a raise at work relate to inflation?

A raise at work is only beneficial if it outpaces inflation. If you receive a 2% raise but prices rise by 5%, your real purchasing power has actually decreased by 3%.

What is purchasing power and why is it important?

Purchasing power is the value of goods and services that can be bought with a certain amount of money. It's important because it determines how much 'stuff' one can consume, and it can increase or decrease with price changes.

How do economists measure inflation in a country?

Economists measure inflation using the Consumer Price Index (CPI), which tracks the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

What is a consumer basket and how is it used in calculating the CPI?

A consumer basket is a list of goods that represents what an average consumer buys in a year. The prices of these goods are added up for each year, compared to a base year, and used to calculate the CPI.

What is the difference between 'nominal' and 'real' values in economics?

Nominal values are the actual prices recorded without any adjustment for inflation. Real values are past prices that have been adjusted to reflect their value in today's currency, taking inflation into account.

Why is it necessary to adjust for inflation when comparing historical financial data?

Adjusting for inflation allows for an accurate comparison of financial data over different periods by accounting for changes in the value of money and the cost of goods and services.

What are the limitations of the CPI as a measure of inflation?

The CPI does not account for changes in consumer habits, new products, or improvements in product quality over time. It assumes a constant market basket, which may not reflect real consumer behavior.

What is deflation and how is it different from inflation?

Deflation is a decrease in the general price level of goods and services. It is the opposite of inflation, where prices fall rather than rise.

What are the two main causes of inflation as described in the script?

The two main causes of inflation are demand-pull inflation, where there is too much money chasing too few goods, and cost-push inflation, which occurs when the cost of production increases, causing producers to raise prices.

Can you give an example of a historical bubble mentioned in the script?

One historical bubble mentioned in the script is the Dutch tulip mania in the 1630s, where the price of tulip bulbs skyrocketed due to speculation and then collapsed.

Outlines

00:00

📈 Understanding Inflation and Its Impact on Purchasing Power

This paragraph introduces the concept of inflation, its effects on purchasing power, and the importance of adjusting for inflation when comparing prices over time. Adriene and Jacob engage in a quiz that highlights the general perception of rising prices. The discussion moves to how inflation erodes the value of a raise if prices increase faster than wages. The paragraph also explains the concept of purchasing power through the character Stan, illustrating how it is affected by price changes. Finally, it outlines the topics that will be covered in the video, including the measurement of inflation, international comparisons, and the phenomenon of economic bubbles.

05:01

💰 Causes and Examples of Inflation and Deflation

This paragraph delves into the causes of inflation, such as demand-pull inflation where increased money supply leads to higher prices, and cost-push inflation resulting from a decrease in the availability of resources. It uses Venezuela's economic situation as a case study to illustrate the effects of mismanagement and printing money, leading to soaring prices. The paragraph contrasts inflation with deflation, as seen in Japan, and discusses the difference between nominal and real values when considering historical economic data. It also touches on the imperfections of the Consumer Price Index (CPI) and its adjustments for technological progress.

10:04

🏠 Economic Bubbles and Their Consequences

The final paragraph discusses the nature of economic bubbles, using the examples of the housing market in the early 2000s, the Dutch tulip mania in the 1630s, and the stock market bubble in the late 1990s. It explains how bubbles form due to speculation and the expectation of perpetual price increases, leading to unsustainable market conditions. The paragraph highlights the role of easy credit, deceptive lending practices, and the psychology of investors in bubble formation. It concludes with the inevitable bursting of bubbles and the significant economic repercussions that follow, emphasizing the importance of understanding these phenomena for personal financial decision-making.

Keywords

💡Inflation

Inflation refers to the general increase in prices over time, which erodes the purchasing power of money. It is a central theme in the video, illustrating how a raise in wages might not be a 'real' increase if prices rise at a faster rate. For example, if wages increase by 2% but prices rise by 5%, the purchasing power of the individual actually decreases. The video discusses how inflation is measured using the Consumer Price Index (CPI), which is a key tool for adjusting past prices to present-day values and for understanding economic trends.

💡Purchasing Power

Purchasing power is the value of a currency in terms of the goods and services it can buy. It is a fundamental concept in the video, showing how it can increase if prices fall or decrease if prices rise. The video uses the character Stan to explain that purchasing power is directly affected by inflation, as it determines how much 'stuff' one can consume. For instance, if the price of pizza or Neutral Milk Hotel tickets goes up, Stan's purchasing power for these items decreases.

💡Consumer Price Index (CPI)

The Consumer Price Index is a measure that tracks the average change in prices paid by urban consumers for a market basket of consumer goods and services over time. The video explains that economists use CPI to compare the cost of living between different years by adjusting for inflation. It is used to calculate 'real' values versus 'nominal' values, as seen when determining the highest grossing movies of all time, adjusting their earnings to a common base year's prices.

💡Deflation

Deflation is the opposite of inflation, where there is a decrease in the general price level of goods and services in an economy. The video mentions Japan as an example where prices have been falling slightly over the past 25 years, which is a state of deflation. This concept is important as it contrasts with the more commonly discussed inflation and shows different economic scenarios.

💡Demand-Pull Inflation

Demand-Pull Inflation occurs when the demand for goods and services exceeds supply, leading to an increase in prices. In the video, it is explained through a scenario where people with a lot of money bid up the prices of goods, causing inflation. This is an example of 'too much money chasing too few goods,' which is a classic case of demand-pull inflation.

💡Supply Shock

Supply Shock refers to a sudden change in the supply of a good or service that leads to a change in the price. In the video, an example is given where an oil shortage increases the price of gasoline, which in turn raises the cost of delivering ingredients for pizza, leading to cost-push inflation. This concept is important for understanding how disruptions in supply can affect the economy and cause inflation.

💡Bubble

A bubble in economics refers to a situation where the price of an asset or a group of assets experiences a sudden large increase followed by a dramatic decline. The video discusses various historical bubbles, such as the Dutch tulip mania and the housing bubble of the early 2000s, to illustrate how irrational exuberance and speculation can lead to unsustainable price increases and eventual crashes.

💡Speculation

Speculation is the act of buying an asset with the hope that its price will rise in the future, often based on the belief that others will also want to buy it, leading to higher prices. The video uses the housing bubble as an example, where people bought homes in the belief that prices would continue to rise indefinitely, leading to a speculative bubble.

💡NINJA Loans

NINJA Loans, which stands for No Income, No Job, and No Assets, were a type of subprime mortgage loan that contributed to the housing bubble. The video mentions these loans as an example of deceitful lending practices that allowed more people to buy homes, increasing demand and prices, which ultimately led to the bubble bursting.

💡Nominal vs. Real

Nominal values are the actual prices or costs without any adjustment for inflation, while real values are adjusted to reflect the purchasing power of money over time. The video explains the importance of using real values when making historical economic comparisons, such as determining the highest grossing movies of all time, to account for changes in the value of money.

💡Economist

An economist is a professional who studies the production, distribution, and consumption of goods and services. Throughout the video, economists are referenced for their role in analyzing and explaining economic phenomena such as inflation, deflation, and bubbles. They use tools like the CPI to measure and understand these phenomena, as well as to provide insights into economic policy and decision-making.

Highlights

Inflation is the general rise in prices over time, impacting purchasing power.

A raise in wages may not be a real increase if inflation outpaces it.

Purchasing power is the measure of how much physical goods one can consume based on price levels.

Economists use the Consumer Price Index (CPI) to measure inflation and adjust past prices to today's dollars.

The CPI is calculated by comparing the cost of a consumer basket of goods over different years.

Adjusting for inflation allows for accurate comparison of earnings or costs across different time periods.

The difference between 'nominal' and 'real' values in economics is crucial for historical comparisons.

Inflation can be caused by demand-pull factors where consumers bid up prices of goods and services.

Supply shock, such as a decrease in availability of resources, can lead to cost-push inflation.

Venezuela's economic mismanagement and political instability have resulted in soaring inflation.

Bubbles occur when the price of a good soars due to collective delusions and irrational exuberance.

The housing market in the early 2000s was characterized by a speculative bubble, leading to a crash.

Bubbles are unsustainable and burst when there are no more buyers willing to pay inflated prices.

Understanding inflation is practical for negotiating real wage increases and making informed economic decisions.

Historical examples of bubbles, like the Dutch tulip mania, illustrate the dangers of speculative markets.

Economists use adjustment factors to account for technological progress and maintain comparability over time in CPI calculations.

Transcripts

Adriene: Jacob, you're a teacher, so on behalf of students everywhere, Pop Quiz on you! What

was the average price of a new car in 1950? What was the tuition at Harvard in 1900? What

was is the highest grossing movie of all time?

Jacob: Sharknado? Adriene: Yeah.

Jacob: Really? Adriene: No.

[Theme Music]

Adriene: When it comes to inflation, most people think prices go up over time. Ok, I get it. Who cares?

Well, you do. A lot. Let's say you got a two percent raise at your job. But while you're

raking in your extra two percent, prices rise by five percent. Guess what. That means you

didn't get a real raise. Sorry. After adjusting for inflation, you're actually losing three

percent of your purchasing power.

Well, let's take a look at Stan. Hello, Stan. Purchasing power tells him how much physical

stuff, like pizza, haircuts, and Neutral Milk Hotel tickets he can actually consume. If

prices go down, he can consume more stuff. His purchasing power has increased. Or if

prices go up, he has to consume less. His purchasing power has decreased. A rise in

prices is effectively the exact same thing as a cut in wages, and vice versa.

The first thing we need to know is how economists measure inflation, or the overall price levels

in a countries. Using that measure they can do things like adjust prices from the past

into today's dollars, and give us a reading on how fast prices are rising.

Second, we're going to look at inflation and talk about what leads one country to have

inflation while another has falling prices. Finally, we're going to look at bubbles, which

happen when the price of just one good soars, as a result of collective delusions and irrational exuberance.

Jacob: We all know that prices tend to go up over time. The average movie ticket in

the U.S. today is $8.00. In 1939, when Gone With The Wind was released, it was 23 cents.

So to compare box office sales between different years, we have to adjust for inflation. But

how do we do that? I mean, the prices for some things are rising quickly, like college

tuition and health care. And for other things it's rising slowly, like for cars and food.

But, prices for stuff like electronics, are even dropping. Stan, how much are DVD players again?

So when they're adjusting for inflation, economists first pick out a list of goods that represents

what an average consumer buys in a year. Say, twelve months of rent, three hundred gallons

of gasoline, fifty loaves of bread, twenty burritos, and seven movie tickets. That kind

of thing. It's called a consumer basket. They add up the price of this year's basket, and

do the same thing next year, and the year after that. So eventually you have a long

list of basket costs for a bunch of different years.

Then, you pick a base year. It can be any year you want. You divide the basket cost

of each year, by the basket cost in the base year and multiply it times 100. That gives

you something called the consumer price index. The CPI shows how prices have changed between

different years, and it's by far the most commonly used measure of inflation.

Adriene: To determine, the highest grossing movie of all time, we have to adjust for inflation.

Gone with the Wind, Avatar, and Star Wars were all made in different years, with different

ticket prices. The CPI allows us to adjust for inflation by leveling the playing field

and putting all the earnings in the same base year prices. You'll hear economists using

the words "nominal" and "real" a lot.

"Real" means that a price from the past has been adjusted for inflation. "Nominal" means

a price from the past that hasn't been adjusted for inflation. So the highest "nominal" box

office receipts list is quite different. Avatar, Titanic, Avengers, Jurassic World. Of course,

most of these movies are more recent, since ticket prices are higher today. But the point

is, when economists make historical comparisons, they always use "real" values.

It's worth noting that the CPI isn't perfect. Since we have to keep the market basket constant

over time, a traditional CPI won't adjust for either new products on increases in product

quality. So a market basket from the 1950s might include a black and white TV that gets

like, a few channels and weighs like, a "billion" pounds. It's nothing like your 40-inch flat screen.

Government economists use adjustment factors to simultaneously account for technological

progress and keep two different years comparable. But, it's very complicated. Economists can

also use the Consumer Price Index to calculate the rate of inflation, how quickly the price

level is rising from year to year.

Here's the rate of inflation over time, and as you can see, prices grew slowly in the

'50s and '60s, sped up during the '70s and '80s, and when back to growing slowly. On

the other hand, here's the rate of inflation in Japan. For the past 25 years, prices in

Japan have actually been falling slightly. Economists call that deflation. And here's

the rate of inflation in Venezuela. The past several years have seen prices rising very

fast there. At the end of 2014, the inflation rate was nearly 70%. But what causes inflation?

Let's go find out in the Thought Bubble.

Jacob: So let's assume we gave John $10 million U.S. dollars. Is he rich? Well, not if you're

stuck on a desert island. Being rich isn't about how much money you have. It's about

how much purchasing power you have. Let's put John back into society so he can start

buying stuff. If other people also have a lot of money, they're going to bid up the

prices of goods and services. That last slice of pizza is $2.00, but Hank might offer $3.00.

John might counter-offer $10.00. Actually this might be a bad example since John and

Hank would probably share the pizza. They're brothers.

The point is that if people have a lot of money and they want to buy more stuff, they're

going to bid up the prices of things, causing inflation. This is actually called Demand

Pull Inflation. In the language of economists, it's "too much money, chasing too few goods."

Now a nother cause of inflation is the decrease of availability of an important productive

resource, like oil or something. An oil shortage, would increase the price of gasoline, increasing

the cost of delivering flour, and cheese, and pepperoni. This would increase the cost

of producing pizza. And therefore decrease the number of pizzas that can be produced.

Economists call this Supply Shock, and it causes something called Cost Push Inflation.

So, to keep it simple, inflation is caused by either consumers bidding up the prices

of stuff, or producers rising prices and producing less, because there's an increase in production

cost. Either way, inflation is the result of having more money than goods and services.

Adriene: Thanks Thought Bubble. So, who's got inflation today? Venezuela. In the 1950s

and 60s and 70s, Venezuela had one of the strongest economies in Latin America with

stable inflation. It's also a country with huge amounts of oil. But this is Case Number

478 that natural resources don't equal economic bliss.

Economic mis-management and political instability have reduce oil exports from Venezuela. The

government's tried to keep the economy growing by printing more money, but that's only resulted

in soaring prices. It's a bad scene.

But prices go up all the time without necessarily causing inflation. Let's look at the prices

of chocolate over the past few months. and the price of housing ten years ago. Lots of

inflation, right? Well, no.

Jacob: In the case of chocolate, we have a straight forward supply and demand story.

As China and other nations develop, their consumers are spending more on treats, like

chocolate. Also, dark chocolate has become more popular world-wide. Now both of these

trends have increased demands for the coca beans, which is used to produce chocolate.

Now at the same time, disease and drought have limited harvests and decreased supply.

Higher demand and lower supply means higher prices for chocolate.

Now on the other hand, it's hard to explain the rise in home prices with just supply and

demand. The population didn't suddenly skyrocket or get that much richer, and it's not like

there was a shortage in building materials. Between 2001 and 2006, home prices diverged from

these fundamentals, in what economists call "a bubble." In the early 2000s, low interest rates and deceitful

lending practices encouraged more people to buy homes. That raised demand and increased the price.

But then people saw prices increase and assumed it would continue forever. So they liquidated

their beanie baby portfolios and bought houses in hopes of making a huge profit. This is

called speculation. More buyers are pulled into the market and prices rose faster and

faster. In fact, average home prices in the U.S. doubled between 2000 and 2006, and nearly

tripled in cities like Los Angeles and Las Vegas.

There were even more dramatic spikes in home prices in countries like Ireland and Spain.

News stories about rising real estate prices, along with easy credit, convinced even more

people that buying a home was a one way ticket to riches.

Adriene: At the time, there were plenty of people pointing out that rising home prices

were unsustainable. In fact, in 2005 the Economist magazine called the global rise in home prices the

biggest bubble in history. And economists like Robert Shiller and Nouriel Roubini were predicting a crash.

But those warnings couldn't compete with your brother-in-law bragging about how much he

just made flipping a home. Or banks pushing NINJA loans, so more and more people got into

the act. Wait, Stan. There were ninja bankers? That's amazing! Oh, NINJA stands for No Interest,

No Jobs, and No Assets. That's not so amazing.

The problem with a bubble is that depends on an ever increasing supply of buyers,

each person is betting that they'll be able to sell at a higher price to the next

person. But eventually, you run out of buyers and the bubble bursts.

Bubbles aren't a new thing. In the late 1990s there was a stock market bubble for companies

involved in this brand new computer thingy, called the internet. Investors poured billions

of dollars into internet stocks, and they got in on the ground floor of pets.com or

boo.com. It turns out these companies had only one floor, and it a deep, deep basement.

The stock market collapsed in early 2000.

Perhaps the granddaddy of all bubbles was Dutch tulip mania in the 1630s. Tulip gardens

became a social fad among the emerging class of wealthy merchants, driving up their price.

More and more people got in on the tulip action, making quick fortunes. And that brought in

even more people, desperate to get their hands on a tulip bulb. At the height of the mania,

people were willing to exchange twelve acres of land, or ten years worth of salary for a single tulip bulb.

While a tulip bubble sounds incredibly beautiful, incredibly lovely; just floating petals, red and

pink and yellow -- Sorry. What am I talking about? The bubble burst and tulip bulbs are now less than a dollar.

Understanding inflation is not just academic. This affects you. Someday you might have to

ask your boss for a raise. Knowing some economics can help you negotiate a real raise, adjusted

for inflation. Thanks for watching. See you next time.

Thanks for watching Crash Course Economics. It was made with the help of all these nice

people and the greatest bubble of all. Thanks Thought Bubble. If you want to help keep Crash

Course free for everyone forever, consider going over to Patreon. It's a voluntary subscription

platform that allows you to pay whatever you want monthly. Thanks for watching. Don't forget

to be "irrationally exuberant," at least with your feelings.