Inflation, deflation, and capacity utilization 2 | Finance & Capital Markets | Khan Academy

Summary

This video script delves into the dynamics of inflation and deflation, emphasizing that capacity utilization, driven by demand, is more critical than money supply. It illustrates how high velocity of transactions can lead to inflation even with a small money supply, contrasting with scenarios where a large money supply doesn't translate to demand. The discussion touches on historical inflationary periods linked to capacity utilization and the impact of the 1973 oil crisis. It critiques the pre-crisis economic model where consumption exceeded production, financed by debt, leading to unsustainable practices. The script concludes by questioning the effectiveness of government stimulus in a post-crisis environment with decreased capacity utilization and demand.

Takeaways

• 💡 Inflation or deflation is not solely determined by the money supply; capacity utilization, driven by demand, plays a more significant role.
• 🌊 High velocity of money, even with a small money supply, can lead to high capacity utilization and potentially inflation, as seen in the 'island with seashells' example.
• 📉 A decrease in transaction velocity, even with an increased money supply, can result in lower demand and deflation, as people are not expressing demand.
• 📈 Historically, significant inflationary periods have been preceded by substantial increases in capacity utilization, particularly when it reaches the 80% range.
• 🏭 In the 1970s, the oil shock is often cited as a cause for inflation, but the script suggests that inflation was already on the rise due to capacity utilization increases.
• 💸 The script highlights the importance of savings and investment in maintaining and increasing output, which in turn affects capacity utilization and inflation.
• 📉 The 2007 financial crisis led to a demand shock, causing a significant drop in capacity utilization and contributing to deflationary pressures.
• 🌐 The script emphasizes the interconnectedness of global economies, suggesting that changes in one country's economy can affect others, particularly in terms of consumption and output.
• 🏘️ The housing market and home equity loans played a significant role in financing consumption and investment, and their collapse contributed to the demand shock.
• 💼 Government stimulus packages aim to prevent a deflationary spiral by filling the gap left by decreased consumer spending and maintaining capacity utilization.

Q & A

What is the key factor in determining whether we experience inflation or deflation according to the video?

The key factor in determining inflation or deflation is not just the money supply, but more importantly, capacity utilization, which is driven by demand.

How can high velocity of money lead to inflation even with a small money supply?

High velocity of money indicates that people are actively transacting, expressing a high demand, which can lead to high utilization of capacity and potentially cause inflation, even if the money supply is small.

What is the relationship between capacity utilization and inflation as discussed in the video?

Inflation tends to start when capacity utilization reaches the 80% range. When businesses are operating near full capacity, they may choose to raise prices instead of increasing production, leading to generalized price inflation.

How did the oil shock in the 1970s impact inflation, as mentioned in the video?

While the oil shock in 1973 likely contributed to inflation by increasing oil prices, the video suggests that inflation was already on the rise due to increasing capacity utilization, and the oil shock may have just exacerbated the situation.

What is the role of savings and investment in maintaining and increasing output as explained in the video?

Savings are crucial for investment, which in turn increases output. In a responsible economy, a portion of GDP is saved and then invested to boost future output, leading to a higher standard of living.

Why did consumption in the U.S. exceed production leading up to the financial crisis, according to the video?

Consumption exceeded production because of a constant expansion of credit, leading to increased borrowing and consumption, which was not sustainable in the long term.

How does borrowing from other countries to finance consumption affect a country's economy?

Borrowing from other countries to finance consumption can lead to a situation where consumption is larger than output, making the economy reliant on external debt and unsustainable in the long run.

What is the significance of the drop in capacity utilization in relation to inflation and deflation?

A drop in capacity utilization indicates a decrease in demand, which can lead to lower prices and deflation. This is because businesses have excess capacity and may lower prices to attract customers.

What is the government's strategy to prevent a deflationary spiral as discussed in the video?

The government's strategy is to stimulate the economy through borrowing and spending, filling the gap left by reduced consumer spending, to prevent a deflationary spiral where falling prices lead to reduced consumption and investment.

Why is it important to watch capacity utilization numbers when considering future inflation, according to the video?

Monitoring capacity utilization numbers is important because they indicate the level of demand in the economy. High utilization suggests strong demand, which can lead to inflation, while low utilization can lead to deflation.

Outlines

00:00

💹 Understanding Inflation and Deflation

This paragraph discusses the determinants of inflation and deflation, emphasizing that it's not merely the money supply but rather capacity utilization driven by demand that plays a critical role. The speaker uses the analogy of an island with a single seashell as currency to illustrate how high velocity of transactions can lead to inflation even with a small money supply. Conversely, an increase in money supply with reduced transaction velocity can result in deflation. The speaker also highlights the correlation between capacity utilization and inflation, noting that significant inflation typically occurs when utilization reaches around 80%. The paragraph concludes with a brief mention of the impact of the 1973 oil crisis on inflation, suggesting that while it was a contributing factor, the inflationary trend was already present due to increased capacity utilization.

05:01

📉 The Impact of Credit Expansion on Consumption and Savings

The second paragraph delves into the economic changes since the 1980s, marked by an expansion of credit and increased consumption, often financed by borrowing. This led to a situation where average American consumption exceeded production, resulting in a negative savings rate. The speaker explains how this consumption was largely dependent on borrowing from other nations, creating a scenario where the U.S. became a net debtor. The paragraph further discusses the unsustainable nature of this model, as it relied on continuous borrowing to maintain consumption levels. The speaker also touches on the role of investment funded by savings and how it contributes to increased output and standard of living. The paragraph concludes with an examination of the current financial crisis, where the collapse of credit has led to a demand shock, resulting in reduced consumption and investment, and consequently, lower capacity utilization and prices.

10:05

🏛️ Historical Context of Inflation and Deflation

The final paragraph provides a historical overview of inflation and deflation, focusing on the Great Depression as a significant period of deflation. The speaker uses a graph to illustrate periods of inflation and deflation, noting that deflationary periods are typically associated with economic hardship. The discussion includes the impact of World War I and the post-war period under the Bretton Woods system, as well as the 1970s oil shock. The speaker emphasizes the government's role in stimulating the economy to avoid deflation, using the example of the New Deal and the current stimulus efforts. The paragraph ends with a teaser for the next video, where the speaker intends to discuss whether the government's actions will be sufficient to prevent a deflationary spiral.

Keywords

💡Inflation

Inflation refers to the rate at which the general level of prices for goods and services is rising, and subsequently, the purchasing power of currency is falling. In the video, the speaker discusses how inflation is not solely determined by the money supply but is closely tied to capacity utilization and demand. The example of the island with one seashell illustrates that even with a small money supply, high velocity (demand) can lead to inflation.

💡Deflation

Deflation is the opposite of inflation, where there is a decrease in the general price level of goods and services. The video emphasizes that deflation can occur when demand slows down, leading to unused capacity and businesses lowering prices to sell excess inventory. The speaker mentions that the current financial crisis has led to a demand shock, which could potentially result in deflation.

💡Money Supply

The money supply refers to the total amount of money available in an economy at a particular point in time. While the video acknowledges that the money supply can influence inflation or deflation, it argues that it is not the primary driver. Instead, the speaker highlights that it is the velocity of money (how often it changes hands) and demand that truly drive economic conditions.

💡Capacity Utilization

Capacity utilization is the extent to which productive resources in an economy are being used. According to the video, this is a key determinant of inflation or deflation. High capacity utilization, driven by strong demand, can lead to inflation as businesses may raise prices to capitalize on limited excess capacity. Conversely, low capacity utilization can lead to deflation as businesses lower prices to attract customers.

💡Velocity of Money

The velocity of money is the rate at which money circulates through an economy, changing hands from one transaction to another. The video uses the island example to illustrate how a small money supply can still lead to high velocity and thus high demand, potentially causing inflation.

💡Demand

Demand in the context of the video refers to the desire and ability of consumers to purchase goods and services. The speaker argues that demand is a critical factor in determining economic outcomes, as it drives capacity utilization. When demand is strong, it can lead to inflation, but when it slows down, it can result in deflation.

💡Consumption

Consumption is the use of goods and services by individuals and businesses. The video discusses how consumption is a significant part of GDP and is essential for maintaining a good standard of living. However, it also points out that excessive consumption financed by debt, as seen in the U.S. before the financial crisis, is unsustainable and can lead to economic imbalances.

💡Savings

Savings in the video are depicted as the portion of income not spent on consumption, which can be invested to increase future output. The speaker explains that a healthy balance between consumption and savings is crucial for sustainable economic growth. The video contrasts the traditional savings rate in developed nations with the negative savings rate in the U.S. before the crisis.

💡Investment

Investment in the video is discussed as the use of savings to finance new capital goods, infrastructure, or businesses. It is considered essential for increasing output and improving the standard of living. The speaker points out that without savings, there would be no money for investment, which would lead to a decrease in output and economic decline.

💡Credit

Credit refers to the ability to borrow money, which can be used for consumption or investment. The video discusses how the expansion of credit in the U.S. since the 1980s led to increased consumption beyond production levels, creating a dependency on borrowing and unsustainable economic practices.

💡Stimulus

Stimulus in the video refers to government actions, such as spending or tax cuts, intended to boost economic activity. The speaker discusses the government's role in providing stimulus to prevent a deflationary spiral by filling the gap left by reduced consumer spending during a downturn.

Highlights

Inflation or deflation is not solely determined by money supply but also by capacity utilization.

Capacity utilization is driven by demand, which in turn affects inflation or deflation.

An example of an island economy illustrates how high velocity of transactions can lead to inflation even with a small money supply.

Conversely, a large money supply with low transaction velocity can result in deflation.

Every major inflationary bout is preceded by a significant increase in capacity utilization.

Inflation tends to start when capacity utilization reaches the 80% range.

High capacity utilization can lead businesses to raise prices rather than increase production.

The 1973 oil shock's role in inflation is discussed, suggesting it may have added to existing inflationary pressures.

The relationship between savings, investment, and output is explained, emphasizing the importance of a sustainable economic cycle.

The shift from a savings-based to a credit-based economy since the 1980s is highlighted.

The unsustainable situation of U.S. consumption exceeding production is discussed.

The concept of borrowing output from other nations to fuel consumption is introduced.

The current financial crisis is analyzed in terms of its impact on demand and capacity utilization.

The role of government stimulus in filling the consumption gap left by reduced private demand is explained.

The potential for a deflationary spiral and the government's efforts to avoid it are discussed.

The historical context of inflation and deflation, including the Great Depression, is provided.

The video concludes with a teaser for the next part, which will delve deeper into the economic implications of the current situation.

Transcripts

In the last video I spoke a bunch about the determining

factor on whether we have inflation or deflation.

It isn't so much the money supply, although the money

supply will have an effect, it's really capacity

utilization.

Capacity utilization is driven by demand.

And I made that distinction because-- I gave that example

of the island, where you could have a very small money

supply, for example, one seashell, but if the velocity

is really high, then people are expressing that demand.

And you'll have very high utilization of all of the

capacity in the island and you might have inflation, even

though the money supply is one seashell.

On the other hand, let's say, we found a bunch of seashells,

but everyone stops transacting, so the velocity

were to slow down a bunch.

So in that case, even though the money supply is huge, or a

lot larger than it was, people aren't expressing demand.

So demand will be a lot lower than capacity.

As we showed in the cupcakes economics video, when you have

a lot of unused capacity, it's everyone's incentive to try to

sell that extra unit and they all lower prices.

So you can have an increased money supply but, if the

velocity slows down or if demand is slowing down--

because that's what's causing the velocity to slow down--

then you could still have a deflationary situation.

Actually, we touched on the chart where we showed that

every major inflationary bout was actually stimulated, or

was actually preceded, by a pretty big upturn in capacity

utilization.

And the inflation really started going once capacity

utilization got into the 80% range.

You could imagine that if, on average, the world is running

at 80% that means that some people are running at 70%,

some people are running at 90%, 95%.

And those people who are running at 95%, those are the

people who say, gee, instead of trying to run at 96%, 97%,

98% utilization, why don't I just raise price and not have

to worry about producing that extra unit?

And obviously their inputs go into other people's; their

outputs go into other people's inputs.

And then you get a generalized price inflation.

Now with that said, actually, I want to make another point.

In the early `70s-- everyone always talks

about the oil shock.

In 1973 you had the Yom Kippur War.

We resupplied Israel, and then you had all the OPEC countries

that essentially stopped selling oil to the U.S. and a

lot of other western nations.

And people say, you know, oil prices shot through the roof

and that's what drove inflation, that supply shock.

That probably contributed to it, but 1973 is

right around there.

So if you actually look at this chart, we're already kind

of on an inflationary spectrum.

The generalized prices were already increasing.

And capacity utilization had really preceded that.

That probably just added fuel to the flame.

With that said, the question that everyone's wondering

about is, what's going to happen now?

So before the current financial crisis, we had a

certain amount of capacity.

Let's say this is everything, this is the U.S. output.

Let's say this is U.S. GDP, right?

GDP is just output.

So in a normal developed environment, so that you go

back into the `60s-- and I should probably get the

Bloomberg chart on this too, because it's pretty

interesting-- about 60% of our GDP was on consumption.

And consumption always isn't a bad thing.

Consumption isn't always a bad thing.

It's actually what we use to have a

good standard of living.

If I have a nice sofa, and a TV set, and I go on vacations,

that's consumption.

But it improves our standard of living and the goal of all

countries is really to improve that

average standard of living.

But the remainder is savings.

In a traditionally responsible, developed nation

you save 40%, maybe 30% to 40%, depending on whether

you're Japan or whether you're Western Europe.

Now what savings turns into, is essentially new investment

to raise your ouput.

So this savings is what allows you to increase your output in

the next year.

If you don't save even a little bit, your output will

actually decrease, because no one will invest in factories

and the factories will get old and the roads will stop being

usable and all the rest. Whenever someone's investing,

that's someone else's savings.

And it's very important to realize that investment and

savings are really two sides of the same coin.

If no one's saving, then there's no money for

investment.

But just going back to this example, when people are

saving that's what not only maintains output, but actually

increases total output.

So this would be in the next year or the next decade.

And then, when we consume 60% of this, we're consuming 60%

of a larger number and our standard of living will go up.

And this is a very sustainable and good situation.

What happened, unfortunately, really since the early `80s,

is that we had a constant expansion of credit.

We started lending more and more money to everyone and

other countries started lending more and

more money to us.

And most of that got expressed in more and more consumption.

So if you look at U.S. output-- This is GDP.

If you actually go to 2007, the average American consumed

more than we produced.

We had a negative savings.

If I were to draw that, it looks like this.

In 2007, consumption was larger than our total output.

So the question is, how did this happen?

Everyone talks about money and currencies.

Essentially we borrowed output from other people.

When we borrow money from the Chinese, which we use to buy

their goods, we're essentially just borrowing

their output, right?

We're borrowing their goods.

So when we give them a dollar bill, that's a promise that,

in the future, they could use that dollar bill to come back

and use some of our output.

But over the course of the last several decades, we were

just borrowing other people's output.

And we became net debtors.

So when your consumption is actually larger than your

output, you immediately start to realize that this isn't a

sustainable situation for too long.

And maybe we borrowed a little bit more money and, actually

it did turn out that way, that we borrowed some people's

output even more to fuel some of our investment as well.

It's not like no investment was going on for

the last 20, 30 years.

We had a lot of investment.

But essentially, the consumption and investment was

being financed by other people's output.

And, of course, when you have consumption touching up

against-- you're fully utilized, that makes it even

more an incentive to invest. So all of these people were

willing to invest in the U.S.

What happened now is, you realize that a lot of the

financing or a lot of the debt that was being taken on, it

was being facilitated by people's homes and home equity

loans but people really aren't good for it.

And now all of a sudden, the banks dried up, liquidity is

gone, people can't borrow money, and you

have a demand shock.

So what you have is a situation where a considerable

amount of this consumption, and actually a considerable

amount of that investment that was being fueled by financing,

disappears.

And now that we're in a global world, we really should think

about global output.

But it doesn't matter, we could talk

about just U.S. output.

But now that this demand has disappeared-- if this is U.S.

output and let's say, this is output that we were taking

from China or Japan or wherever else-- and our

consumption has now fallen down here.

And it's not because, all of a sudden, people became prudent.

It's because people aren't willing to lend them, to go to

Williams-Sonoma and buy a $50 spatula or whatever else.

They just can't get another credit card loan or a home

equity loan.

So you have the situation now, where you have low

utilization.

And this comes back to what we talked

about in the last video.

That when you have low utilization, it's everyone's

incentive to lower prices.

When you have a bunch of vacant houses,

people lower rents.

When the car factories are empty, people lower the price

of car factories.

When people are underutilized, wages go down.

You see this shock, more recently, right here.

As we said in the last video, the orange line is U.S.

capacity utilization.

And it dropped from about the 80% range.

If it had gone up here, I would have started getting

worried about hyperinflation.

But, you see, right around summer of 2007 it dropped off

of a cliff and it's down here someplace.

Now you see a little bit later, inflation dropped.

So that dynamic that we've been talking about, capacity

utilization falling off, because we essentially had a

demand shock.

And then that's led to a decrease in prices.

So the question is, everything that the Treasury is doing,

and the Fed is printing money, and Obama spending a

trillion-dollar stimulus, is that

going to lead to inflation?

My answer is, just watch the capacity utilization numbers.

And, just you know, the stimulus plan, the whole idea

about it is, the government doesn't want us to enter into

a deflationary spiral.

If consumption drops like this, we have all of this

capacity and prices go down.

If prices go down a little bit, it doesn't affect

people's behavior in aggregate.

But if people start having expectations that wages will

go down, that prices will go down then, they all go into

panic mode and they stop spending.

Let's say they stop spending, then utilization goes down

even more, then unemployment goes up even more, and this

also makes fear go up even more.

Unemployment going up and fear going up makes people stop

spending even more.

And this is that deflationary cycle that all the economists

and all of the government officials are afraid of.

You saw that during the Great Depression.

Let me draw a zero point to show you where.

That is zero.

That's the dividing line between

inflation and deflation.

You see we've had a couple of bouts of deflation.

And they normally aren't good times in the world.

This is the Great Depression right here.

This is post World War I, and the Great Depression actually

lasted all the way until-- we entered the war in the late

`30s-- right about here to here.

We had a little bit of inflation.

You had the first wave of the New Deal stimulating some

spending, but it really never got us to any significant

level of inflation.

Just so you have a sense, I would consider anything above

5% inflation as really, really bad.

And let me draw a line there.

So that's the 5% inflation mark.

So we really didn't get above 5% inflation until you end up

with World War I, and then you have the postwar period, we're

under Bretton Woods, and then in the `70s we had, as I

talked about before, the oil shock and all of the rest. The

rest is history.

But as you see, the deflationary periods are

things that government officials want to avoid

altogether.

So the idea of the stimulus is for the government to borrow

money, because no-one else can.

And they can essentially fill up the gap where the

consumers left off.

Now the question is, are they going to fill

up enough of a gap?

Actually I realize that I'm running out of time again.

I don't like to make these videos too long, so I'll talk

about that in the next video.