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Inflation, deflation, and capacity utilization

Inflation is associated with an increase in output driven by an increase in aggregate demand, but an overlooked aspect of inflation is the role of capacity utilization. In this video we explore some patters associated with capacity utilization, inflation, and deflation. Created by Sal Khan.

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  • spunky sam blue style avatar for user carsonwilkins
    Which is better, Inflation or Deflation?
    (14 votes)
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    • blobby green style avatar for user Ava Kelly
      @ JeffAxelson - when you say: "can be generally be avoided by proper central bank tools & responsible fiscal policy" -when has either of those two "generally" happened? For the most part it seems the avarice of the government & Fed have have shown they are incapable of using central bank tools properly or being responsible with fiscal policy. All one has to do is look at the current economic situation in the EU & US as proof. That's why Austrian economics is good because it leaves the supply/demand up to the natural market forces
      (6 votes)
  • blobby green style avatar for user Þorsteinn Friðrik Halldórsson
    When he states that he could settle for a Honda instead of a Rolls Royce, at , does he not fail to mention that he would most likely keep his 200,000 dollars in a bank, and the money would go into circulation through bank loans etc.?
    (4 votes)
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  • blobby green style avatar for user Juan
    Why isn't the definition of inflation the creation of money or an increase in the money supply?
    (7 votes)
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  • blobby green style avatar for user charuprakash
    the pattern does not hold between 1989 and 1999 during which the two lines actually diverge,
    (5 votes)
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  • purple pi purple style avatar for user Anya Jacksteit
    Why would capacity utilisation increase inflation? Shouldn't it decrease?
    (2 votes)
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  • blobby green style avatar for user Jose Prado
    Is it correct to say that Sal's point of view is the keynesian one? Money, in his model, is endogenous, and the FED can't control it. If it increases the supply of notes (M0), and if people don't want to spend it (liquidity trap), the velocity of money will go down to compensate the increase in the quantity of notes. The neoclassical theory, on the contrary, thinks that money is exogenous, that FED controls the quantity of money. Inflation, is Sal's view, is not a monetary fenomenon.Is it right?
    (3 votes)
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    • blobby green style avatar for user Beckett Cantley
      This depends on what school of Keynesianism Sal follows. The Neo and Post Keynesians (Harrod, Hicks, Solow, Samuelson, Minsky) believed money to be endogenous (the LM curve being constant) and that supply and demand to be the chief cause of inflation. However, with the rise of rational expectations theory and monetarism school, New-Keynesianism came about. New-Keynesianism agrees with Milton Friedman's famous quote: "inflation, is always and everyone a monetary phenomenon", and postulates that the money supply is exogenous. However, market failures can still lead to liquidity traps. Members of the New-Keynesianism school include Ben Bernanke, Janet Yellen, Olivier Blanchard, Kenneth Rogoff, Paul Krugman (to an extent), John Taylor, and Greg Mankiw. Therefore, Sal's analysis is still Keynesian, depending on the school.

      (4 votes)
  • leaf orange style avatar for user Mikel Perez
    After watching this video I wonder if we may be confusing correlation for causation?

    The graphs show how increases in capacity utilization mostly precede inflation, but that doesn't mean necessarily that utilization is causing inflation, it just shows a correlation between them.

    May there be another underlying factor, like access to cheap consumer credit, or low interest rates on savings, that increase consumer demand / spending, which in turn increases utilization AND causes inflation?
    (4 votes)
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    • mr pants teal style avatar for user Martin Christensen
      if you increase the money supply (which the central bank controls) the interest goes down and demand goes up. Inflation goes up because of the increased money supply and because of the increased demand.

      So yes, there are other factors but that doesn't chance the point he is trying to make that capacity utilization leads to inflation (keeping other factors constant).
      (1 vote)
  • blobby green style avatar for user Chris Borgars-Smith
    I'm not sure why around Sal says that increases in capacity precede increases in inflation, but then at ish measures the capacity at the same time as the inflation upturn to say "this is the threshold utilisation which causes inflation to rise" - surely a) you'd be accounting for that lag and b) any increase in utilisation ought to correspond with an increase in inflation?

    Also, the end of the timeline doesn't seem to be in keeping with this idea - the inflation rate doesn't seem to have much at all to do with the utilisation. Could someone expand on this?
    (3 votes)
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  • spunky sam blue style avatar for user Elias Dorneles
    Wouldn't make more sense, when your service has a low utilization, for you to maintain your prices, and improve its efficiency? For example, make less cupcakes and work on selling it all, so you spend less and wins enough.
    I don't really understand why low utilization alone would lead to a decision to make prices cheaper -- what would probably make it more difficult to improve the service.
    Probably, improving the efficiency or quality of the service/product would make more sense, right?
    (2 votes)
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    • male robot donald style avatar for user josephg
      Yes, but you're thinking logically, with no bean-counters telling you what to do, and you're thinking about the better good of everyone. Rather than being greedy, if you were to increase the quality of your products, in the end, you would seel more, people would be happier with your product, and you could still sell everything at a much lower price.
      (2 votes)
  • blobby green style avatar for user bentagent
    I guess that means that if you want to drive consumption/capacity utilisation via increasing the money supply it makes sense to give that money to those people who do not have enough money to satisfy their demand and therefore won't stuff it in their mattress or savings account. Which i guess would mean we should give money (bailouts) to poor people to get the economy going, no?
    (1 vote)
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    • blobby green style avatar for user MarkJ.A.Barbour
      This is basically what is called Keynesian or "demand-side" economics. It starts to break down when you consider what producers do when there is an increase in household incomes: they raise prices. Why? because there is more money out there to be had and when the money comes from nothing, the value of currency depreciates relative to other goods and services. Keynes' theories regarding demand side econ also break down when you start to see stagflation in an economy (when the rate of inflation and the unemployment rate are tending to rise to a persistently high level). The solution to this based on the theory stated above is to raise inflation to increase the money supply, which will give people more money to spend on goods and services which will create a demand for more jobs. The fallacy in this is that the money isn't worth anything and since the price system works incredibly fast, prices tend to rise before the market can be fooled into thinking there are more goods and services to be had. There are several other reasons why this reasoning is flawed as well, but those, in my opinion, are the most fundamental.
      (3 votes)

Video transcript

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, 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 of 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 classic 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, oftentimes, 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.