Finance and capital markets
Deflation despite increases in money supply
How you can have deflation even if the money supply increases. Created by Sal Khan.
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- I don't think the behaviour of these island people is credible...
Is the main argument that velocity of money and supply of money only via market optimism affect price levels?(21 votes)
- The standard economic theory is the fisher equation MV = PQ (some call it an identity)
M = money supply
V = circulation or velocity of money
P = price level
Q = GDP or output
If you hold Q constant and increase the money supply or the velocity then P increases.
Notice how MV in economics (money supply x velocity) is similar to MV in physics (mass x velocity = momentum). You could think of inflationary pressure being caused by the momentum of money.(104 votes)
- In3:37, shouldn't it be "this would lead to INFLATION"?(28 votes)
- Yeah, seems like it. Him saying "deflation" right there doesn't make sense in context. Sal's had a long day.(25 votes)
- So deflation is really just a measure of money...not necessarily of productivity, right? In the video, it looks like the farmer and the builder are both producing at the the same level as previous years (i.e., GDP is stagnant) and I could imagine a scenario in which they might even produce more.
All this leads to my basic question of why so many economists seem convinced that deflation is so terrible. I don't understand it. Yes, "deflation could hurt producers and help consumers"...but doesn't that statement obfuscate the fact that in a complex economy all of us are BOTH producers AND consumers? Thus, why should it be a general rule that inflation is better than deflation?(7 votes)
- Thanks. That helps some. I can especially see the argument for how deflation would discourage lending (and thus, investment). How would you respond to the argument that even in a deflationary cycle, though, investment wouldn't cease--it would just be better directed, so as to avoid as many poor investments. I'm assuming this is basically the thinking of the Austrian Economists I've heard talk about "malinvestments." Is that right?(2 votes)
- The "bad confidence" that Sal said, can be considered as a negative expectation?(7 votes)
- Instead of giving one coin back and forth (or 1/2 a coin), Why don't they just barter services?(4 votes)
- A very good question.
In economies where the currency is no longer used (or trusted) by a population, alternative forms of exchange are adopted by the people. Bartering becomes more common and alternatives to paper currency such as cigarettes are then traded in the same way paper money was used before.(5 votes)
- Technically, isn't this similar to what Japan is going through? Is there anyone who knows for certain?(3 votes)
- You´re right on Japan going through this, but it was a couple of years ago. A new prime minister´s been elected (Abe), and he´s been focused on reactivating the economy, and it could be argued that he´s done a good job at it.(3 votes)
- So ,isn't this what is happening with the US economy right now?
The money supply has increased with QE and ZIRP yet prices are not increasing as expected and we have almost zero inflation.(2 votes)
- Most would say that that has less to do with a lack of confidence and more to do with the fact that the money is not going into circulation but instead going into banks which don't lend it out.(2 votes)
- Some use deflation to mean a decrease in the supply of money. Others, use it to mean a drop in prices. Likewise some use inflation to mean an increase in the supply of money, while others use it to mean an increase in prices. In the example here, deflation seems to mean a decrease in prices.
How do you define deflation?(2 votes)
- We have two different definitions of deflation. When we say deflation, we normally mean price deflation, which is a decrease in the overall price level. On the other hand, monetary deflation is a decrease in the money supply. Sal explains the difference at https://www.khanacademy.org/economics-finance-domain/macroeconomics/inflation-topic/cost-of-living-tutorial/v/introduction-to-inflation.(2 votes)
- So here, the confidence of the farmer or the builder was that hey, let me pay the other guy, and since business is doing pretty well, that money will probably come back to me! What happens in the case of someone who's got some money but is unemployed, and has no business through which his spendings might come back to him? Also, if there's widespread unemployment, could this directly lead to deflation? Since people wouldn't be spending as much.(2 votes)
- It all depends on what the aggregate demand curve looks like. Unfortunately, the aggregate demand changes almost all the time, so ratios will change through time.(2 votes)
- Does the farmer lower his price only because he wants to use his max capacity or also in hopes that a lower price will stimulate more demand from the builder?(1 vote)
- The farmer lowers his price because that is all the builder is willing to pay him. The builder isn't willing to pay any more, and so buys the cheapest most basic food necessary to survive.(4 votes)
Let's revisit the island or the universe that only has a farmer and a builder in it. Let's think about a different scenario. Let's think about a scenario where they each start off with a lot of physical currency. We're in a universe that's starts off with much more physical currency than the last example. Where the universe had only 4 gold coins. Let's say that the farmer right over here starts off with ... and I'll right down the number instead of drawing the coins. Actually let me draw the coins, that's kind of fun. Let's say he starts off with 5 gold coins, and the builder also starts off with 5 gold coins. Entering into this year, the farmer is feeling pretty pessimistic. He goes to the builder. He tells builder look I just want the base level of construction or maintenance or whatever going on in my farm today. I can only afford 1 coin of business from you, or what you can do for 1 coin. He gives that coin to the builder. The builders feeling pretty pessimistic. Normally the farmer starts off the year much better than that. He says that this clearly going to be a bad year. I'm only going to buy my base necessities for food. He goes to the farmer and says look even though I have ... he's not going to tell the farmer that he's hoarding all of his cash. He's going to say look farmer, things are bad, business is bad, I'm preparing for the worse. Just give me the base minimum, cheapest, simplest, food you can that'll keep me alive. So, he only gives 1 coin back to the farmer. Imagine that the money supply actually increases. For whatever reason the farmer digs around in his backyard and finds some more gold. Then the builder, also, while building a building actually discovers a huge chest of gold right over here. Their still feeling pretty pessimistic. Maybe their just pessimistic people. The farmer despite this increase in the money supply, this gold that he discovers. He's like how frequently am I going to discover gold like that. That was just a one off thing a bonanza that I just happened to run into. The business itself is pretty bad. It was even worse last year then it normally is. I'm going to spend as little as possible. I'm going to go to the builder, and I'm going to say look things seem to only be getting worse. I can only afford half a coin worth of what you have to offer, before this base maintenance. The builders thinking gee. That's even worse than last year, but I have all this extra capacity I could be building so much more. I have people who aren't working. Sure, I'll take it. I'll take your half coin, and I'll deliver that same service for that half of a coin. He does it, and essentially, his price had gone down despite the fact there's more currency. The builder, even though he dug around and found all this gold, he's feeling even worse. The price of what he's offering has gone down. He's got even less revenue in total in absolute gold coins now. When he goes to the farmer. he's like, I have to buy that base level food. Otherwise, my family's going to starve. Business is worse than ever. I'm so pessimistic. He doesn't even tell the farmer that he discovered all of this. That he's hoarding all of this. So, he's say farmer, i can just afford half a coin worth of stuff. The farmer says well I guess so, since the building prices have gone down, and I can buy more with that half of coin. I have all this surplus labor, and surplus capacity on my farm. Sure, I will take a half of coin for the same thing last year I took a full coin for. You see the situation where deflation is occurring even though the money supply has increase. Of course, I'm exaggerating things. In normally if you have this large of bonanza, and the money supply, people would start to get optimistic and would start to spend money. It would probably lead to deflation. The main point here is to realize that it isn't just driven by the absolute quantity of the currency. That's important, but just as important are confidence and what confidence drives, and that's specifically the velocity of money. The transactions of money. The higher the velocity ... or quantity matters. But quantity times velocity what really drives the level of prices.