Inflation, deflation, and capacity utilization A discussion of inflation and deflation
Inflation, deflation, and capacity utilization
- With all the talk of the deficits that we're entering, and the stimulus bill,
- and all the money that's being spent on the bank bailouts, and potentially the auto bailouts,
- the question that everyone's asking: Is this going to lead to inflation?
- And that is what I hope to address in this video.
- And I guess a good starting point is, well, what is inflation?
- It's a general increase in the prices of goods and services.
- So they actually measure it by-- they take a basket of goods and services
- and they see how those prices compare to a reference year.
- And if those prices go up by 3%, they might use a consumer price index.
- They'll say inflation increased by 3%. So that's what's inflation.
- And the opposite of inflation, if things actually get cheaper, is deflation.
- If one year 10 megabytes of RAM costs x dollars, and then the next year, it costs a little bit less,
- it's actually a deflationary process, at least in that market.
- So without the those definitions out of the way, let's talk a little bit about what causes it.
- A couple of days ago, I made these videos on cupcake economics, where I talked about what happens
- when the cupcake factories have high utilization or low utilization.
- What might happen with prices?
- And the reason why I did that is because I really want to make it very clear
- that it really is utilization of factories or of people that drive prices.
- Let's say this is all the capacity that I have.
- When I talk about capacity in this video, I'm speaking in very general terms.
- It's all of the goods and services that we could produce.
- We could just talk about labor capacity,
- and then unemployment rate is a measure of what is essentially not being utilized.
- But this is just our capacity, our productive capacity.
- And in those cupcake economics videos, I showed that if the demand is pushing up against capacity.
- let me do demand in a different color. If demand is really close to capacity--
- and I know everything I draw kind of looks like balance sheets,
- but this isn't intended to be a balance sheet.
- This is intended just to show you that demand is pushing up against capacity.
- So in this situation, let's say, this is capacity.
- If demand is at 90% of capacity, then the people with the capacity might say, gee,
- instead of trying to just try to sell that extra unit-- this is demand-- instead of just trying to sell that extra unit
- and have to worry about all the raw materials and have to work for that extra unit,
- why don't I just raise prices, right?
- So high utilization of capacity, it leads to prices increasing.
- And this isn't some kind of fancy macroeconomic principal;
- it's true if you're running a lemonade stand.
- If all of a sudden, you're starting to sell 95% of your lemonade,
- you'll probably say, hey, maybe it's worth it if I raise the price.
- On the other hand, low utilization-- let me pick another color --will lead the prices dropping.
- And you go back to your lemonade stand, and you say,
- wow, if I'm only selling 20% of the lemonade that I make,
- maybe my problem is that my lemonade's too expensive.
- And frankly, if there was a bunch of lemonade stands, everyone is trying to sell their capacity.
- So just to compete with each other, they'll all lower prices.
- Actually, I'll throw another thing in here that's a little unrelated to inflation,
- but high utilization makes prices go up and it also makes people want to add more capacity, right?
- So also investment goes up.
- Both of those things do add more capacity, but we won't worry about that right now.
- So if you accept that-- and I think it's a reasonable argument,
- because it's really based on common sense things --then I think you'll buy the argument that,
- if you have very low utilization, it's difficult to have inflation.
- And, likewise, if you have very high utilization, it's hard to avoid inflation. And to kind of hit the point home,
- actually, I took our company's Bloomberg terminal and copied and pasted these charts here.
- And the orange-- and I know you can't see it that well on YouTube , so I'll try to make it clear in my drawing,
- But this orange I'll do it the same color, --this orange shows capacity utilization,
- and the starting date right here, I think it was 1967.
- This is 1969, actually December 31, 1969, so this is 1970, beginning of 1970,
- this is beginning of 1980, beginning of 1990, this is 2000.
- This orange line represents capacity utilization.
- So up here this is 90% utilization and then down here this is 70% utilization.
- So if we look here, in the late 60's, we have very high utilization.
- Arguably because of the Vietnam War, we had factories running at capacity to build bombs
- and Agent Orange and God knows what else. And then utilization went down.
- We could talk a lot about the history, but, in general, the interesting thing-- well, actually,
- before I go into what happened, let's think about what this white line is.
- So the orange line is utilization. Up here we had like 90% utilization.
- Very recently, this was like 2007, we had 80%, and very recently, utilization has dropped off,
- which essentially just means we're not running our factories at full tilt.
- This white line is year-over-year inflation growth, and let me do that in white.
- This is year-over-year inflation growth.
- Actually, let me draw a zero line, so you can separate inflation from deflation.
- Let me see, zero inflation is right over here. That's zero inflation.
- And you see, in the time series that I've done, we've never had zero inflation,
- although we have had periods of a very high inflation.
- But the interesting thing, just falling into the cupcake economics
- and this whole notion of capacity utilization, is that inflationary periods are always preceded,
- at least all the data I have, by increases in capacity utilization.
- So you could view this as the beginning of a pretty significant uptick in prices, right?
- And notice, it was preceded by an uptick in capacity utilization.
- So, if you saw right here, wow, capacity utilization is starting to go up-- and actually,
- another interesting thing is to see what threshold of utilization starts to trigger inflation.
- So over here, you say, OK, when inflation really started turning around,
- we were at a capacity utilization of roughly 83%, 84% right there.
- And then, if you look at the next period where inflation really started to hit--
- you can either pick that point or that point --where was capacity utilization?
- It was around that same level that was right there. It was above 80.
- This was about 82%. And we could pick every period before that.
- Well, since then, inflation really hasn't been a major problem.
- These are our two major bouts of inflation, in the early 70's and in the early 80's,
- and those were when we had extremely high capacity utilization.
- So the point I want to make here is capacity utilization really is the driver of inflation.
- You actually could find it the other way around.
- So this white line here, you don't see it because the orange line--
- actually, I realize that I'm showing you off the screen.
- Let me actually reduce my window, so I can show you.
- So this is more recent, where we see that capacity utilization started falling off.
- I think this is in the summer of 2007. And you don't see it there
- because it's overwritten, but the inflation line has also dropped considerably.
- It comes down to here. But notice once again, although here it's pretty close,
- but utilization dropped off a couple of quarters before inflation dropped off.
- And that's why I always wonder why the Federal Reserve Board of Governors,
- they always talk about different inflation indicators and what to do about interest rates,
- when you do have a pretty good indicator, and that's capacity utilization.
- The next question that everyone has is, OK fine, Sal.
- Capacity utilization drives inflation. We can all buy that.
- But clearly, what's going on right now is just a wholesale printing of money.
- And won't the wholesale printing of money drive demand to go up,
- and then we'll have very high capacity utilization,
- and then we'll have inflation or even hyper-inflation?
- And my argument there is that's normally the case. Normally,
- if you increase the money supply, if the money supply goes up, that should increase demand.
- But there's a subtle, and it's almost a philosophical point,
- but it's an important one, to realize: Money just allows you to express demand.
- Let's say I really, really want to buy a Rolls Royce, I just don't have the money.
- If someone gave me $200,000 into my pocket, then I could express that demand to buy the Rolls Royce.
- On the other hand, let's say, I have everything I need.
- I'm happy with my Honda and my two-bedroom apartment, and someone gave me $200,000.
- So they've increased, at least, my money supply.
- Will that increase the demand for the Rolls Royce? No.
- I have money to express the demand, but I won't do it, because I don't think it's necessary.
- So you can make that same analogy in the economy as a whole,
- where you can imagine an island where, let's say,
- there's five of us or three of us, because I don't want to draw five people.
- And between us, we use seashells as a currency. And we're very confident.
- And maybe I'm the builder, and this guy's the fisherman, and she's the farmer.
- Let's say in one year I use a seashell to get some fish.
- And then he uses that seashell to buy some crops.
- Then she uses that seashell to buy a house.
- And I use that seashell again to buy more fish. You can see that one seashell,
- even though my money supply on that island is one seashell, it can transact many times in that year.
- So the velocity in this example is very high.
- So you notice that my expression of demand happens in these actual transactions.
- I'll do a classical money supply equation soon.
- But you could imagine another reality, where, for some reason, I stop trusting this guy.
- I've become very cautious, and I say, well, you know what?
- I don't want to give him my seashell, because I'm not sure
- if I'm going to get that seashell back again to do something else.
- So you can imagine a reality where the central bank of our island,
- all of a sudden, they find hundreds of seashells.
- And they put seashells in everyone's pockets so we're all full of seashells.
- But all of us have lost so much confidence in the economy,
- or are so unsure over whether other people are going to use my goods and services,
- that I don't want to use their goods and services. So we all just start hoarding seashells.
- So this is a situation where the money supply could actually increase pretty substantially,
- but since no one wants to express it through demand, it's not going to increase utilization.
- And so in the situation that we're in right now, if you're wondering about
- whether you're going to see inflation or deflation, my argument is look at capacity utilization.
- People can point to the money supply. This is a classic money supply equation.
- The money supply times the velocity of money-- that's how often the actual dollars switch hands --
- is equal to the price of the average price of goods times the total quantity of goods and services we have.
- So most people say, wow, if the money supply increases, then won't prices increase?
- Well, that would be true if you assume that velocity and quantity are constant.
- But we're saying that whenever you have major shocks and people lose confidence,
- this velocity can slow down considerably, especially when things like financial intermediaries
- start hoarding money and people start putting money into their mattresses.
- In fact, often times, people don't even consider things that aren't being transacted money.
- For example, those commemorative coins that they sell on TV.
- They're not considered part of the money supply, because people don't use them as money.
- Anyway, I'm all out of time. I'll continue this discussion in the next video.
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At 5:31, how is the moon large enough to block the sun? Isn't the sun way larger?
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When naming a variable, it is okay to use most letters, but some are reserved, like 'e', which represents the value 2.7831...
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