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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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Video transcript

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.