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Deflation despite increases in money supply
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.