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

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

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.


  • DavidAKZ

    March 31, 2009

    Can you translate the relationship of capacity utilisation to demand in the context of Credit Default Swaps (CDS) ,, Structured Investment Vehicles (SIV) and derivatives

  • DavidAKZ

    March 31, 2009

    US GDP. 80% consumption and 20% defence ?

  • pongman

    March 31, 2009

    If Sal would stop making videos he could be the next Secretary of Treasury.

  • Tooomps Challenge

    March 31, 2009

    People talk a lot about the stimulus as if it were all government spending, but in fact much of it is tax cuts, and tax breaks. Also, worth noting is that much of the tax cuts simply replace the one from last year.

  • Depatres

    April 3, 2009

    Im no economy expert but..
    I believe deflation also means lower wages and unemployment; better actually deflation is a result. Prices drop because cap. ultilization drops, people have less money to spend or are more careful when spending, lowering demand and suddenly there is a gap between production and demand. Yes its a blessing for those who were prepared or lucky or are gadget fanatics from Europe, but overall degrading for economy on the long run.

  • Depatres

    April 3, 2009

    But now, people will rather save money + its harder to get credit to buy things), rather than than buying. (which what all the economists are afraid of). Because companies arent able to sell things as quicly as before first lower their production, invest less into innovation (survival mode – cap .utili drops) and later start lowering prices so they can sell what stored in warehouses. Prices drop yes, but some have lost their job anyway so its meaningless to them.

  • Depatres

    April 3, 2009

    So now the thing is not to fall into the deflation cycle which happened in Japan in the 90's after the housing buble burst. They call it the 10 lost years. How not to go the same way, I do not know..

  • BigBruddah101

    April 4, 2009

    Cap Util should only be high in the short run given expansion and the entering of new firms would occur, no?

    If high Cap Util continues in long run, would indicate another issue: lack of info to key expansion, barriers to entry, excessive demand, lack of capital/saving/investing?

    Didn't we leave a true gold standard in 1933 (not 1971) when gold redemption clause on money was repudiated in defiance of Section 8 of the constitution, allowing dollar to fluctuate and government to revalue/print?

  • pjblabla

    May 18, 2009

    I recommend watching the you tube channel


  • klitschko88

    August 12, 2009

    at least for now.

  • srvkkar

    June 4, 2010

    @flyingparadise I agree, "inflation is not rice."

  • lorax2013

    September 17, 2010

    Deflation is mostly only bad for the banks and other leveraged speculators. IMO that is why the establishment puts out the myth that deflation is bad. In reality deflation is just a normal deleveraging which occurs when overleveraging collapses. The government only fights it in order to prop up the banks and wealthy investors who would otherwise take a bigger loss. That's the shortest explanation I can give for a complex topic.

  • Korianne75

    October 22, 2010

    i think we are going for deflation if you look the graph at about 10:53 you can see it. We are headed in a deflationary period. But who knows maybe the devaluation of currency might inflate prices while deflation itself is dropping them.

    Comment back im trying to learn this STUFF THX!!

  • pdeg001

    November 27, 2010

    @Korianne75 It all depends on what action the Federal Reserve takes. If the Fed keeps bailing out corporations and banks, monetizes the government debt, and monetizes loans that are in danger of defaulting, there will be massive inflation – possibly hyperinflation. If the Fed lets everything default, there will be massive deflation – worse than the 1930s. Unfortunaetly, deflation is the better action to take so markets can restructure.

  • frother

    April 1, 2011

    There's no inherently true price for a good. As inflation goes up, that just means that the dollar is worth less, not that the good costs more.

    What you really care about is the rate of price increase of the good compared to the rate of price increase of other goods and the rate of wages increase.

  • mrhnm

    July 26, 2011

    @frother What I care about is getting money out of my savings account and into something like silver.
    Because inflation devalues your money faster than the interest the bank gives you compenstates. Id est your money loses value every time the FED prints money. They are stealing from you.

  • mrhnm

    July 26, 2011

    @TheCIAsucks Look into Austrian Economics.

  • TallFastLoud

    September 22, 2011

    @flyingparadise a) inflation is bad for the rich — who generally have the highest savings rate — and not bad at all for people with lower rates of savings, especially those who are able to obtain wage increase that correspond with inflation. we actually can live with persistent inflation (we always have SOME degree of inflation), which isn't bad provided it doesn't get out of control. falling prices are actually bad for people who need to borrow frequently (i.e. the worse off sectors and

  • TallFastLoud

    September 22, 2011

    @flyingparadise small businesses [which rely more on borrowing than issuing stocks/bonds.]) Your comment is nearly exactly the opposite of the consensus on these things.

  • Devarajan Sv

    September 23, 2011

    @TallFastLoud Appreciate your views, however i believe current sacrifice in consumption and saving is what builds your future. You cannot always keep on borrowing all the time. You save today, sacrifice today and that allows to set up your future comfortably. same goes for buying a house, building a business. You save today, sacrifice today and build tomorrow. Borrowing again and again to pay back earlier debt is nothing but a ponzi scheme and that cannot be sustained forever.

  • TallFastLoud

    September 30, 2011

    @yahodeva well, debt is necessary to a certain degree, whether you like it or not. I do totally agree about the demerits of excessive debt. however, real wages have been stagnating for a while now in the US, meaning that aggregate demand could no longer drive growth. as Ford would've said 'you have to sell the shit to someone.' since income inequality soared and wages stagnated or fell, we had to give the lower/middle classes some purchasing power to maintain growth and that came via cheap

  • TallFastLoud

    September 30, 2011

    @yahodeva credit. There are three options: we can have your plan of 'no debt and no wage increases' and have torpid growth; we can increase purchasing power (but not wages) via unsustainable debt; or we can increase real wages to match productivity growth. The idea that it's a 'lesser of two evils' choice between the first two options is a sign of how far right the economic consensus has moved in this country.

  • Abhinav Gautam

    October 8, 2019

    Really well explained. Thank you!!


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