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Course: Finance and capital markets > Unit 3
Lesson 2: Inflation scenariosStagflation
How a supply shock can cause prices to rise and the economy to stagnate. Created by Sal Khan.
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If prices are going up everywhere then why don't profits also increase everywhere?(35 votes)- Two points:
(1) Inflation affects both the price of inputs into production, and the price of the product which is produced. That means that although you might sell your goods for more, it cost you more to produce them, so profit is not necessarily higher.
(2) You need to be careful to distinguish between nominal profits and real profits. Because prices are going up, money is becoming less valuable. So a £10 profit if the price of bread is £1 a loaf is much better than a £10 profit if the price of bread is £2 a load. Is is therefore possible that nominal profits may rise (say, profits go from £10 to £10.50), but real profits go down (say because the price level has doubled, so you're £10.50 goes less far than £10 at the old prices).(110 votes)
- Can some give a clear definition of stagflation then? I now know what it is, however I would like it in a single sentence.(13 votes)
- Stagflation is simply that the economy is not growing, stagnation, but there is still inflation.(54 votes)
- Ok so if price of the oil went up, then why would the demand go down? I thought that if there is less of something, demand for it would increase because people are going to need it more but the supply would not be there. Just cause prices go up won't stop people from needing oil to get to work everyday. Could someone please explain?(13 votes)
You're right that rising prices will not stop people from needing oil, however people will conserve it more (car pool/use public transport, etc) and also be a lot more careful about how much they buy. Also, it's not just demand for oil that goes down when oil prices rise, it's demand for everything (or most things) that require oil to produce/transport. So you will get a decrease in people spending on unnecessary luxuries if it's hitting their pocket hard.(32 votes)
- Ok, I understand that the collapse in oil supply causes prices to increase, and this has a knock-on effect on demand, utilization, employment and wages. The part I don't understand is: if wages and unemployment collapse and demand collapses, then shouldn't prices become reduced again, thus curbing inflation? For example people would buy less goods, these goods would not have to be transported, less oil purchased, oil prices fall, all prices fall. I don't understand how this cycle could result in sustained inflation. Is it because oil is such an essential resource that the demand for it can only fall so much?(8 votes)
[Edit: I created this for you – http://www.geogebratube.org/student/m47140?mobile=true – to visualize the impact of shifts to supply and demand. Notice that when you shift supply in (i.e., left), price level goes up and real GDP drops, which is stagflation. Shocks to the supply curve won't necessarily impact demand, which seems to be what you're asking in the original question.]
I would invite you to draw a graph charting supply and demand. Note where your equilibrium point is. Now, shift the supply curve in (to the left). Notice what happened to your equilibrium point? Quantity dropped and price went up.
Now, if you're familiar with the AD-AS model, it plots aggregate supply and aggregate demand. However, instead of price versus quantity it graphs price level (vertical) versus real GDP (horizontal). Consider the same shift of supply (AS). Price level increases and GDP drops. Basically, you are getting inflation while the economy stagnates. It is stagflation, and it's bad.(9 votes)
- When did happen a real oil embergo in USA?(4 votes)
In October 1973, the member nations of OPEC declared an embargo on all petroleum shipments to the US in retaliation for the perceived support of Israel after it was attacked by Egypt and Syria on Yom Kippur.(11 votes)
I'm not sure there's a good answer to this, but what makes the difference between a drop in supply and stagflation? Clearly supply can decrease without causing pervasive stagflation, is it just a question of scale or intensity?(4 votes)
It is a question of scale and intensity, because depending on the magnitude of the supply shock, it could send prices over the Feds target inflation rate: somewhere between 2%-3%. Above this threshold you have the classic definition of stagflation: simultaneous recession and high inflation.(5 votes)
At1:11he says if supply goes down, the price goes up.Does that not contradict the law of supply which states that quantity supplied is directly proportional to price of the commodity?(2 votes)
At some point in this video or section, Mr. Khan says that each second any money that is sitting around is going lesser in value. So if people have cash sitting around their house, how do they invest (being less than 18 years old) it to keep the value flowing with the increase of inflation?(2 votes)
Research says inflation accounts for about 3% on AVERAGE for the past decade. Put simply, you need to make more than 3% interest in any investment in order to beat inflation and not have the money lose it's value. The easiest way to do this is by investing in well managed mutual funds. Decide how aggressive you want to be with your portfolio and research funds with the stock to bond breakdown that you're comfortable with. Look at well established funds that have good rates of return, seeing how well it performed during 2008 is a good starting point. At under 18 you should be invested heavily in stock funds as you have a LONG time to let that compound interest start working for you. However you'll likely have to have someone over the age of 18, like a parent or guardian open the account in your name.(1 vote)
- What does utilization mean in this context?(2 votes)
- Will stagflation happen again in the near future?(1 vote)
Probably not. The Fed has learned from its mistakes, and probably won't make the same mistakes again. This time, it will make a different mistake.(2 votes)
1:11Video transcript
We've learned that a
moderate level of inflation is normally associated
with a good economy. But what we saw-- in particular,
we saw in the early '70s, in 1973, when the
oil embargo hit-- is that we started to experience
something called stagflation, or something that was
labeled stagflation. It's this weird,
bizarre circumstance where you have inflation
at the same time as the stagnation
in the economy. So that's where they get
this kind of combination of words, of stagflation. Let's think about how
that would happen. In particular, let's
think about how that would happen due
to a supply shock. There's other ways that
you could get stagflation if you have strange
regulations, over-regulation, if the government
does weird things. But the classic example
is a supply shock. When we say supply shock, it's
something like an oil embargo, where all of a sudden
the supply of oil, the supply of something,
just goes down dramatically. And it could be because
of some type of emergency, or it could be literally
because of an embargo. And just think
about how that would affect the rest of this chain. So if the supply of something
dramatically goes down-- We know that supply has
an inverse relationship with price. So if supply goes down,
then, bam, right there, you see price would
immediately go up. And when we think about
something like oil, you might say, hey, oil is
only the part of my pocketbook where I drive around. But it's not, because
even when you buy a fruit, you're really paying for
the transportation cost. So the price of oil affects
fruit, affects food, affects any good in services. It's one of these things that's
pervasive through the economy. So the prices of a bunch of
things could generally go up. Well, if the price of a bunch
of things generally go up, what's going to
happen to demand? Once again, inverse
relationship right over here. Demand is going to plummet. If demand plummets, utilization
plummets, investment plummets, and profit is going to plummet. And profit's going
to plummet now because, one, utilization
is going down, and price has gone up. But it's not the price that
they can sell things at. Now price is fundamentally
a big cost for-- especially if you think of it from a
US-centric point of view, if oil is an import, as in the
case of the early '70s, then price going up is
going to have, I guess they have an
inverse relationship. So the price goes up. It's really going to
be on the cost side. So once again,
hitting profits hard. And if all of these
things go down, that's just going to kill
employment, kill wages, and then further make
demand even worse. So stagflation is
that situation where you have some type of
shock to the system, where in the classic scenario
it hits supply so hard it causes a massive inflation
in one part of the economy, and as is the case
of oil, a part that affects other parts
of the economy. And then all of that kind
of throws a monkey wrench in everything else.