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Deflationary spiral

One of the biggest worries associated with deflation is a deflationary spiral, in which low unemployment and a decreasing price level leads to lower unemployment and an even lower price level. Created by Sal Khan.

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  • leaf green style avatar for user Paul Kïttson
    Has this happened recently or is this more theoretical?
    (19 votes)
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  • piceratops ultimate style avatar for user Matúš Mikuš
    So how can one break this deflationary spiral?
    (13 votes)
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    • leaf green style avatar for user Ryan
      It's usually a combination of things. Normally lowering interest rates makes credit available to more people who can then take on riskier business projects that will create growth. Increased government spending on different projects can also create employment and growth. The government can also offer tax breaks to businesses and individuals in an attempt to increase their profits, which should in turn increase employment and demand.

      But it's hard to say what the exact formula is. As Sal mentions, this loop can be very difficult to break. Japan has been struggling with this for over two decades now.
      (29 votes)
  • leaf green style avatar for user beng.smith
    I may be really missing the point - but why, if Japan is in a deflationary spiral as everyone has commented, are living costs in Japan reported as always very high? From the diagram it shows a deflationary spiral leading to low prices.
    (13 votes)
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    • leaf green style avatar for user Ryan
      A couple of reasons.

      Inflation is calculated based on goods that do not change. If a new and innovative product (like a smart phone or tablet) comes along it will cost more, but inflation won't necessary go up. Inflation will only go up if products that don't change (like chocolate bars) go up in price.

      Also, the cost of living is dependent on many different things, not just inflation. There is inflation of goods and services, inflation of wages, population density, scarcity of resources, strength of the country's currency, interest rates available for savings. All of these things are not perfectly correlated. There are many situations where an economy can experience deflation, yet prices may remain elevated for extended periods of time.
      (13 votes)
  • blobby green style avatar for user Mariachi702
    If price of goods and services has gone down, why do people hoard their money? Wouldn't they be able to buy more things since the price of goods and services is so low?
    (6 votes)
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    • blobby green style avatar for user Justin Lillard
      While they may (and many, presumably would, wait longer) they wouldn't wait indefinitely, right? Eventually, you'll make certain purchases because you must have a place to live (i.e. buy a house or rent), food to eat, etc. Not to dismiss with the painful consequences of a deflationary spiral, but it seems to me that this is a good way of wringing stupid debts/purchases out of the economy. Everyone starts paying a lot closer attention to how they spend their money, and starts making sounder investments. Am I wrong in this?
      (4 votes)
  • male robot hal style avatar for user Tim Rizk
    At Sal suggests that velocity will become zero. Isn't this impossible since everyone will have to spend a certain amount of money on food, shelter, etc. ? We would see this deflationary spiral in non-essential industries, but wouldn't there be growth in the essential industries?
    (2 votes)
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    • blobby green style avatar for user Chad Conway
      Although the money in the economy will still be spent on necessities (and so it's velocity will not be zero), at Sal is speaking only about the new ten dollar bills that have been dropped from the helicopter. Since 100% of this new money is going directly in savings, it will not be spent, and so its velocity will effectively be 0. Thus, even though the money supply has increased by dropping new money from the helicopter, the new money has a velocity of 0, and so the total velocity of the now-larger money supply will not have increased. Since the velocity of the money supply has not increased, simply adding additional money to the money supply will not lead to inflation (at least not immediately).
      (4 votes)
  • marcimus pink style avatar for user Agnieszka
    How does an inflationary spiral occur?
    (1 vote)
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    • leaf green style avatar for user Ryan
      Most cases of hyperinflation have at least one thing from the following list:

      1. Very corrupt government
      2. Foreign denominated debt, or a pegged currency
      3. Loss of war
      4. Regime change
      5. Collapse in production and spiking unemployment

      When one or more of the above happens and the central bank responds to the problem by rapidly increasing the money supply, then inflation increases to the point that people completely lose faith in the currency.
      (7 votes)
  • blobby green style avatar for user Samuel Jacques
    deflation isn't bad in and of its self like if the factories put out more and are more efficient then prices would deflation because of supply i think the whole deflation spiral is more to do with emploment that anything else in that example as deflation for most people is great means we can buy more and buying more stuff should in thoery make the profits bigger cos sales are higher am i right in sayint this
    (3 votes)
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  • leaf green style avatar for user Phoenix
    What is the difference between Deflationary Spiral and Stagflation?
    (1 vote)
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  • male robot hal style avatar for user sahan yerram
    If the supply goes down wouldn't prices go up
    (1 vote)
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    • duskpin ultimate style avatar for user Michael Tu
      Supply and demand, in a traditional sense is a very powerful force that can drive prices, but what Sal is saying is that the direct correlation between demand and prices, such as low demand in turn drives low prices as inventory piles up and liquidation needs to happen. At least that's my take on it.
      (4 votes)
  • leaf green style avatar for user luka.krapic
    If there is negative feedback between Supply and Price then decrease in Supply should increase Price. This part of diagram is reasonable enough so it is safe to assume that it is incomplete. Anyone objects?
    (2 votes)
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    • primosaur ultimate style avatar for user Oliver Worley
      Not if the demand also decreases. Companies will lower prices shift the stuff in their warehouses. Supply is down because it would be a waste of money to make more. I think you are thinking of when a company creates artificial scarcity (think designer labels). Essentially in this case they use clever physiological techniques to increase price to insane levels over supply (which they keep low on purpose to help fuel their illusion of exclusivity)
      (2 votes)

Video transcript

So in a normal economy we know that employment will drive overall demand. If we have high employment or low unemployment, then people are going to have more jobs, and they're going to have higher wages, and that will have higher demand. Or if the other way goes around, if they lose their jobs, demand is going to go down, wages will start to go down, and people aren't going to have money in their pockets. So employment drives demand. And we can view the demand-- and I'm making a huge simplification here-- demand will drive production. Or maybe we could think of it as supply. It'll drive supply, and it can also be a driver of price. And of course, there is a little bit of a negative feedback loop for both of these things. If the demand is high and the price goes high, that might produce a little bit of negative feedback on the demand. Instead of an arrow, this line here means negative feedback. I'll put a little negative sign here. And let's say the demand is high and then the supply goes high. Well actually, the supply going high would drive the price going down. So maybe I should draw a negative feedback like here. High supply would mean lower price. But that's not what I want to focus on in that video. And we could keep adding more lines here. But this is roughly simple take on it. But the general idea is supply and price will then drive corporate profits, or just profits in general, even for an individual business owner. And then profits are going to drive employment. Now, let's imagine a scenario. We are in a bad economy, maybe a depression-like economy. So in that situation, you could start really at any point in this circle. I'll just start at employment. So let's say employment is really low. That's going to make demand really low. And if demand is really low, then supply is going to go down, and price is going to go down. And then that's going to make profits go down. And that's going to make employment even lower. And so what we find ourselves in this kind of recessionary or depression area environment, this would be called a deflationary spiral. And it's a spiral because a bad economy is driving lower prices, which is in turn driving a bad economy. And to make matters worse, if this continues long enough, or if these price declines are severe enough, you could imagine people saying, look, I have this dollar in my pocket. I'm not going to spend this dollar because, one, I might lose my job at any moment, and I know that that dollar is becoming more powerful, that I can buy more every minute that I wait. So as the price goes down, so as all of this scary stuff happens-- so the employment is going down, profits are going down, prices going down-- this makes people not hoard goods the way that they would do in an inflationary spiral. But it makes them hoard money. And why it's ultra scary for central bankers or for governments is they start to not have as much control over the economy. They can't just run the printing press and try to stimulate the economy in this situation, because if they did people are so conservative right now-- You could imagine maybe a depression is going on for years and years and years. And let's say that they take some type of a helicopter-- And this isn't how you actually distribute money to the money supply, but it's just to show an extreme example. So they take a helicopter, and they start dumping cash on people. They print cash, and they start dumping it on people. So every man, woman, and child in the country gets a $10 bill. Well, if people are really scared and really afraid, they're just going to take that $10 bill and stuff it into their mattress, and it's not going to change anything. That dollar isn't going to actually enter into the money supply. The velocity on it will be 0.