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How a supply shock can cause prices to rise and the economy to stagnate. Created by Sal Khan.

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  • blobby green style avatar for user Adam Levy
    If prices are going up everywhere then why don't profits also increase everywhere?
    (35 votes)
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    • blobby green style avatar for user robinlinacre
      Two points:

      (1) Inflation affects both the price of inputs into production, and the price of the product which is produced. That means that although you might sell your goods for more, it cost you more to produce them, so profit is not necessarily higher.

      (2) You need to be careful to distinguish between nominal profits and real profits. Because prices are going up, money is becoming less valuable. So a £10 profit if the price of bread is £1 a loaf is much better than a £10 profit if the price of bread is £2 a load. Is is therefore possible that nominal profits may rise (say, profits go from £10 to £10.50), but real profits go down (say because the price level has doubled, so you're £10.50 goes less far than £10 at the old prices).
      (111 votes)
  • blobby green style avatar for user Roshan Abeysekera
    Can some give a clear definition of stagflation then? I now know what it is, however I would like it in a single sentence.
    (13 votes)
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  • blobby green style avatar for user Matthew
    Ok so if price of the oil went up, then why would the demand go down? I thought that if there is less of something, demand for it would increase because people are going to need it more but the supply would not be there. Just cause prices go up won't stop people from needing oil to get to work everyday. Could someone please explain?
    (13 votes)
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    • spunky sam blue style avatar for user Xamadot
      You're right that rising prices will not stop people from needing oil, however people will conserve it more (car pool/use public transport, etc) and also be a lot more careful about how much they buy. Also, it's not just demand for oil that goes down when oil prices rise, it's demand for everything (or most things) that require oil to produce/transport. So you will get a decrease in people spending on unnecessary luxuries if it's hitting their pocket hard.
      (32 votes)
  • blobby green style avatar for user zurith2
    Ok, I understand that the collapse in oil supply causes prices to increase, and this has a knock-on effect on demand, utilization, employment and wages. The part I don't understand is: if wages and unemployment collapse and demand collapses, then shouldn't prices become reduced again, thus curbing inflation? For example people would buy less goods, these goods would not have to be transported, less oil purchased, oil prices fall, all prices fall. I don't understand how this cycle could result in sustained inflation. Is it because oil is such an essential resource that the demand for it can only fall so much?
    (8 votes)
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    • starky ultimate style avatar for user Geoff Ball
      [Edit: I created this for you – http://www.geogebratube.org/student/m47140?mobile=true – to visualize the impact of shifts to supply and demand. Notice that when you shift supply in (i.e., left), price level goes up and real GDP drops, which is stagflation. Shocks to the supply curve won't necessarily impact demand, which seems to be what you're asking in the original question.]

      I would invite you to draw a graph charting supply and demand. Note where your equilibrium point is. Now, shift the supply curve in (to the left). Notice what happened to your equilibrium point? Quantity dropped and price went up.

      Now, if you're familiar with the AD-AS model, it plots aggregate supply and aggregate demand. However, instead of price versus quantity it graphs price level (vertical) versus real GDP (horizontal). Consider the same shift of supply (AS). Price level increases and GDP drops. Basically, you are getting inflation while the economy stagnates. It is stagflation, and it's bad.
      (9 votes)
  • blobby green style avatar for user Danny
    When did happen a real oil embergo in USA?
    (4 votes)
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  • leaf green style avatar for user Amory
    I'm not sure there's a good answer to this, but what makes the difference between a drop in supply and stagflation? Clearly supply can decrease without causing pervasive stagflation, is it just a question of scale or intensity?
    (4 votes)
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    • eggleston green style avatar for user vincenzo
      It is a question of scale and intensity, because depending on the magnitude of the supply shock, it could send prices over the Feds target inflation rate: somewhere between 2%-3%. Above this threshold you have the classic definition of stagflation: simultaneous recession and high inflation.
      (5 votes)
  • piceratops ultimate style avatar for user sarthak mehra
    At he says if supply goes down, the price goes up.Does that not contradict the law of supply which states that quantity supplied is directly proportional to price of the commodity?
    (2 votes)
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  • leaf orange style avatar for user Jojo Jingleberry
    At some point in this video or section, Mr. Khan says that each second any money that is sitting around is going lesser in value. So if people have cash sitting around their house, how do they invest (being less than 18 years old) it to keep the value flowing with the increase of inflation?
    (2 votes)
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    • male robot hal style avatar for user Aaron Garlits
      Research says inflation accounts for about 3% on AVERAGE for the past decade. Put simply, you need to make more than 3% interest in any investment in order to beat inflation and not have the money lose it's value. The easiest way to do this is by investing in well managed mutual funds. Decide how aggressive you want to be with your portfolio and research funds with the stock to bond breakdown that you're comfortable with. Look at well established funds that have good rates of return, seeing how well it performed during 2008 is a good starting point. At under 18 you should be invested heavily in stock funds as you have a LONG time to let that compound interest start working for you. However you'll likely have to have someone over the age of 18, like a parent or guardian open the account in your name.
      (1 vote)
  • blobby green style avatar for user aarav.dodhia1
    What does utilization mean in this context?
    (2 votes)
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  • blobby green style avatar for user Dave Mac
    Will stagflation happen again in the near future?
    (1 vote)
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Video transcript

We've learned that a moderate level of inflation is normally associated with a good economy. But what we saw-- in particular, we saw in the early '70s, in 1973, when the oil embargo hit-- is that we started to experience something called stagflation, or something that was labeled stagflation. It's this weird, bizarre circumstance where you have inflation at the same time as the stagnation in the economy. So that's where they get this kind of combination of words, of stagflation. Let's think about how that would happen. In particular, let's think about how that would happen due to a supply shock. There's other ways that you could get stagflation if you have strange regulations, over-regulation, if the government does weird things. But the classic example is a supply shock. When we say supply shock, it's something like an oil embargo, where all of a sudden the supply of oil, the supply of something, just goes down dramatically. And it could be because of some type of emergency, or it could be literally because of an embargo. And just think about how that would affect the rest of this chain. So if the supply of something dramatically goes down-- We know that supply has an inverse relationship with price. So if supply goes down, then, bam, right there, you see price would immediately go up. And when we think about something like oil, you might say, hey, oil is only the part of my pocketbook where I drive around. But it's not, because even when you buy a fruit, you're really paying for the transportation cost. So the price of oil affects fruit, affects food, affects any good in services. It's one of these things that's pervasive through the economy. So the prices of a bunch of things could generally go up. Well, if the price of a bunch of things generally go up, what's going to happen to demand? Once again, inverse relationship right over here. Demand is going to plummet. If demand plummets, utilization plummets, investment plummets, and profit is going to plummet. And profit's going to plummet now because, one, utilization is going down, and price has gone up. But it's not the price that they can sell things at. Now price is fundamentally a big cost for-- especially if you think of it from a US-centric point of view, if oil is an import, as in the case of the early '70s, then price going up is going to have, I guess they have an inverse relationship. So the price goes up. It's really going to be on the cost side. So once again, hitting profits hard. And if all of these things go down, that's just going to kill employment, kill wages, and then further make demand even worse. So stagflation is that situation where you have some type of shock to the system, where in the classic scenario it hits supply so hard it causes a massive inflation in one part of the economy, and as is the case of oil, a part that affects other parts of the economy. And then all of that kind of throws a monkey wrench in everything else.