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Inflation, deflation, and capacity utilization 2

The role of capacity utilization and the potential for deflation is explored in more depth. Created by Sal Khan.

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  • blobby green style avatar for user cheng.faith
    What is consumption? The spending of money?
    (25 votes)
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    • blobby green style avatar for user jamalontario
      In this series on inflation you demonstrate a correlation between capacity utilization and inflation. How would explain high inflation in the less developed economies i.e. Pakistan, Vietnam, Philippines etc. where capacity utilization is low yet inflation is high. Credit, over all price level etc. also stoke inflation. I am not sure if you have oversimplified the concept of inflation or a developed world centric view point.

      I enjoy your videos a lot, it is a great way of spending quality time. I wish my kids could get on more often.
      (10 votes)
  • leaf green style avatar for user khan.student
    What does GDP stand for?
    (14 votes)
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  • leaf green style avatar for user khan.student
    what are home equity loans?
    (4 votes)
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  • blobby green style avatar for user Aric Diamond
    If unemployment is just a measure of capacity utilization, then theoretically if we aren't using our full capacity shouldn't we lower "prices" to raise demand? By this I mean isn't it logical to lower minimum wage to get companies to start hiring again in order to bring us back to a normal consumption/investment economic model?
    (2 votes)
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    • blobby green style avatar for user Nathan Stiles
      If you have .8/1 million working at %100 minimum wage, and lower the min wage to 90% to allow .9/1 million working you still do not have any change in the volume of money, unemployment would decrease but there would be no change in aggregate demand, nor capacity utilization, nor consumption/investment.
      (2 votes)
  • blobby green style avatar for user Imran Zaidi
    Sal sells seashells by the shore. If the money supply increases doesn't this devalue the currency and that's what increases the price? The inflation is then not in price but in the supply of money.
    (3 votes)
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    • blobby green style avatar for user bobman_jct
      Yes, that will happen - but it might not happen immediately. In the short term, people might hoard money instead of spending it, so you don't see any inflation. However, in the long term, yes. Increasing the money supply will always increase prices unless that money gets hoarded forever. Nobody hoards money forever, and those that do tend to invest it, so it enters the economy anyway.

      I'm not sure why Sal doesn't address this.
      (2 votes)
  • starky ultimate style avatar for user Sudhanshu Sisodiya
    6.06 borrwing the money from the other coubtry and usingnit to buy their goods..i do t get that part. Can't we borrow money and use it in anyway we want to use it? Help me out here.
    (1 vote)
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    • ohnoes default style avatar for user Tejas
      Not exactly. The lender will probably want to know what you are going to use the money for, so that the lender knows that he or she will be paid back, but if the lender is reasonably sure that he or she will be paid back, then you will get the money.

      However, that is not what Sal at was talking about. He was talking about the fact that we were giving them dollars in exchange for their output. When we give another country (which doesn't use the dollar) a dollar, that is basically a promise that they can spend it in the United States later. So basically we are borrowing their output, and the dollar is just an IOU saying that we owe them some of our own output.
      (5 votes)
  • blobby green style avatar for user glenkaiser06
    How do explain the relationship between SERVICES and Inflation, or foreign manufacturing and USA manufacturing capacity utilization. It seems both of these (Services demand and foreign manufacturing) make the historical relationships you show from the 1920s to not very well explain the reality of 2010 for either inflation or GDP or savings (remember 401ks aren't measured in household savings).
    (3 votes)
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  • aqualine ultimate style avatar for user Alexander  Speicher
    At , Sal talks about borrowing money/goods from the chinese. How can I imagine somthing like that, who is borrowing from whom exactly?
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      When you buy something that was made in China, someone in China gets your dollars, and you get a piece of merchandise. That person in China might not want to hold dollars because she can't spend them in China, so maybe she exchanges them for Chinese currency, but then someone else in China has the dollars. So unless someone in China is going to use the dollars to buy something from the US, and pay in dollars, there are going to be extra dollars in China, until they decide to spend them.

      If you add this up across the whole economy, what it means is that there are a lot of dollars in China. What should those people do with them if they don't want to buy merchandise from the US right now? They can instead buy US government bonds, which will pay them interest.

      Anyone who buys a bond is essentially holding a loan made to the US government. So ultimately what has happened here is that the US has taken goods from the Chinese, and the Chinese have been paid with interest bearing securities instead of non-interest bearing dollar bills.
      (5 votes)
  • blobby green style avatar for user alb.cab94
    If consumption goes down then people have the fear of loosing all their money, so they do not spend it which makes unemployment go up and then nobody is selling anything right? Then why are prices going up instead of going down? Or are people just assuming that even if they lower their prices nobody is going to buy anything so they just increase their prices and take more money from the people that are actually consuming?
    (2 votes)
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    • blobby green style avatar for user Chris Vincent
      prices are going up because of the increase in money supply.the government is keeping interest rates low so that they could sustain that demand which existed before.thus everytime that capacity utilisation decreses the government steps in and gives people cheaper credit so that people could continue buying those goods
      thus they keep pushing up prices
      (2 votes)
  • blobby green style avatar for user nst500
    So in a service based economy, capacity utilization = labor utilization? In Florida were I live this is why home prices will keep falling, we truly have a service based economy.
    (2 votes)
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Video transcript

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.