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Current time:0:00Total duration:4:04

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 and let's think about a different scenario let's think about a scenario where they each start off with a lot of physical currency or we're in our universe that starts off with much more physical currency than the last example where the whole universe only had four gold coins so let's say that the farmer right over here starts off with and I'll write down the number instead of drawing the coins let's say he starts off with five actually let me draw the coins that's kind of fun so let's say he starts off with with five gold coins and the Builder also starts off with five gold coins but entering into this year the farmer is feeling pretty pessimistic and so he goes to the Builder and he tells builder look I just want the base level of construction or maintenance or whatever going on on my farm today I can only afford one coin of business from you or what you can do for one coin so he gives that coin to the Builder now the Builder is feeling pretty pessimistic normally the farmer starts off the year much better than that he says this is clearly going to be a bad year so I'm only going to buy my base necessities for food so he goes to the farmer says look all even though I have you know he's not gonna tell the farmer that he's hoarding all this cash but he's going to say look farmer things are bad business is bad I'm preparing for the worst just give me the base minimum cheapest simplest food you can that'll keep me alive and so he only gives one coin back to the farmer now imagine that the money supply actually increases for whatever reason the farmer digs around in his backyard and finds some more gold and then the Builder also while building a building actually discovers a huge chest of gold right over here but they're still feeling pretty pessimistic maybe they're just pessimistic people and so the farmer despite this increase in the money supply this gold that he discovers he's like you know how how frequently I'm 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 so I'm and it was even worse last year than it normally is so I'm going to spend as little as possible so I'm going to go to the Builder and I'm gonna say look things things seems to only be getting worse I can only afford half a coin worth of your of what you have to offer before this base maintenance and the builders thinking well gee you know 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 I'll delete deliver the same service for that half of a coin and so he does it and so essentially his price has gone down despite the fact that there's more currency and so 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 and absolute gold coins now so when he goes to the farm he's like look I need to buy that base level of food otherwise my family's going to starve but business is worse than ever I'm so pessimistic he doesn't even tell the farmer that he discovered all of this and he's hoarding all of this and so he says farmer I can just afford half a coin verse worth of stuff and the farmer says well I guess so since the building prices have gone down and I can buy more with that half a coin and I have all of this surplus labor and surplus capacity on my farm sure I will take a half a coin for what I for the same thing that last year I took a full coin for so you see the situation where deflation is occurring even though the money supply has increased and of course I'm exaggerating things that normally if you had this large of a bonanza and the money supply people would start to get optimistic and would start to spend money and it probably would lead to deflation but 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 our confidence and and what confidence drives and that's specifically the velocity of money the transactions of money the higher the velocity that that or or quantity matters but quantity times velocity is what really drives the the level of prices