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Current time:0:00Total duration:12:32

Inflation, deflation, and capacity utilization

Video transcript

with all the talk of the deficits that we're entering in the stimulus bill and all the money that's being spent on you know though the bank bailouts and potentially the auto bailouts the question that everyone's asking is 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 well it's it's it's a general increase in the price of goods and services so you know they actually measure it by they take a basket of goods and services and they see how those prices compared to a reference here and if those prices go up by 3 percent you know they they might use a Consumer Price Index they'll say inflation increased by 3 percent so that's what's inflation and the opposite of inflation is if things actually get cheaper is deflation if one year a 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 with that with those definitions out of the way let's talk about a little bit about what causes it a couple of days ago I made these videos on cupcake economics where I talked about you know what happens when the cupcake factories have high utilization or your lower utilization what that might happen with prices and the reason why I did that is because I really wanted to make it very clear that it really is utilization of factories or of people that drive prices so if I have let's see if this is all the capacity that I have when I talk about capacity in this video I'm peaking 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 is a is a measure of what is essentially not being utilized but let's just talk about that this is just our capacity our production productive capacity and that those cupcake economics videos I show that if 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 the demand is pushing up against capacity so in this situation let's say you know this is capacity if demand is at 90 percent of capacity then the people with the capacity you might say gee instead of trying to just try to sell that extra units 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 when when so the high utilization let me write that down high utilization of capacity it leads to prices increasing and this isn't some kind of fancy macroeconomic principle it's true if you're running a lemonade stand if all of a sudden you're starting to sell 95 percent 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 low utilization oops low utilization sation will lead to prices dropping and you go back to your lemonade stand and you say wow you know with if if I'm only selling 20% of the lemonade that I make maybe my problem is that I'm not making I'm not I my lemonade 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 there are all lower prices and actually I'll throw another thing in here that's a little unrelated to inflation but high utilization it makes prices go up and it also makes people want to add more capacity right so it also investment goes up both of those things to 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 it's really based on I think 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 these charts here and the orange I know you can't see it that well on YouTube so I'll try to make it clear with my drawing but this orange and I'll do it the same color this orange shows capacity utilization and the starting date right here was I think it was 1967 1967 this is 1969 roughly nine team actually December 31st 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 percent utilization and then down here this is 70 percent utilization so if we look here in the late what is this this is the late 60s right here we had 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 you know we could talk a lot about the history but in general the interesting thing well actually before I go into kind of 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% utilization and then very recently utilization has dropped off which essentially means we're not you know running our factories at full tilt this white line is year over year inflation groans let me do that in white this is year over year inflation groans I'm actually let me draw a zero line so we can separate inflation from deflation so let me see zero inflation is right it's right over here that's zero inflation and you see in this time series that I've done it we've never had zero inflation although we have had periods a very high inflation but the interesting thing in the just falling into the cupcake economics and this whole notion of capacity utilization is that capacity inflation inflation era periods are always preceded at least all the data I have by increases in capacity utilization right so this is kind of you can view this let me see if I can mark this up you could view this as the beginning of a pretty significant inflationary a pretty significant uptick in prices right and notice it was preceded by an uptick in capacity utilization so if you saw right here while capacity utilization is starting to go up and actually an end of the interesting thing is to see what threshold of utilization starts to trigger inflation so over here you say okay when inflation really started turning around we were at a capacity utilization of roughly I don't know 83 84 percent right there and then if we 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 it was right there it was above 80 this is about 82 percent and we could pick every period before that so like when did inflation inflation well you know since that inflation really hasn't been a major problem you know these are our mate are two major bouts of inflation in the early 70s and in the early 80s and those were when we had extremely high capacity utilization right extremely so the point I want to make here is capacity utilization really is the driver inflation and you actually could find it the other way around so this white line here you don't see it because the orange line Oh actually I realize that I'm showing you off of the screen but let me actually 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 utilization dropped off 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 now the next question that everyone has okay fine so you know capacity utilization drives inflation we can all buy that but clearly clearly what's going right now is kind of just a wholesale printing of money and won't the wholesale printing of money drive demand to go up and then you will have very high capacity utilization and then we'll have inflation or even hyperinflation and my argument there is that's normally the case normally when if you increase the money supply normally if the money supply goes up that should increased 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 right 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 you know my two-bedroom apartment and someone gave me a $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 demand but I won't do it just 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 you know there's five of us or let's say three of us because I don't want to draw five people and between us we use seashells as a currency right and we're very confident and you know maybe I'm the I'm the Builder and this guy is the fisherman and she's the I don't know she's the farmer and then I use in 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 it seashell again to buy more fish so you can see that that one seashell even though my money supply on that island is one seashell it can transact many times on that in that year so the velocity in this example is very high right so you notice that my expression of demand happens in these actual transactions and not all go to kind of the classical money supply equation soon but you could imagine another reality where for some reason I don't I you know I stopped 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 could imagine a reality where you know the central bank of our island all of a sudden they find hundreds of seashells and they put seashells in everyone's pockets you know so we're all full of seashells but all of us are have just lost so much confidence in the economy or is so unsure or 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 we're if you're wondering about whether you're going to see inflation or deflation my argument is look at cat capacity utilization people can point to the money supply they could say that yo you know money supply and this is the classic kind of money supply equation that the money supply times the velocity of money that's how often Villette the actual dollar 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 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 and whenever you have major shocks and people lose confidence this velocity can slow down considerably especially when things like financial intermediary start hoarding money and people start putting money into their mattresses in fact oftentimes people don't even consider things that aren't being transacted money for example those commemorative coins that they sell on TV they are 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