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Deflation

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Explore the basics of deflation, including the definition of deflation, how the CPI changes when there is deflation, and why economists tend to be concerned when deflation occurs. Created by Sal Khan.

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  • blobby green style avatar for user isaac.yonemoto
    "deflation is not the norm, especially for growing economies" - but the US economy certainly grew between 1860 and 1900, and there was deflation?
    (24 votes)
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    • blobby green style avatar for user mharring54
      No, the US was under a gold standard for most of the era. The problem was growth was uneven due to the stickiness of relative prices. The resulting misallocation of resources required severe economic contractions to correct prices, especially in wages and employment. The period experienced positive long-term growth with deflation, but erratic or volatile boom and bust cycles. Deflation can be a sign of a productive economy, but especially painful for debtors.
      (24 votes)
  • female robot grace style avatar for user katieldouglass
    How come some of the finance videos are on the Khan Youtube site, but they're not on this site? For example, on Youtube there's videos about the debt ceiling and FICA tax, but I can't find them on this site!
    (11 votes)
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  • leaf green style avatar for user Yusuke Ohashi
    I often face the situation that I can't find a good which was sold 6 month ago, especially about the computers and the smartphones etc..
    In that case, it's supposed that I can't compare the previous price with current one. How do they measure the CPI?
    (3 votes)
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    • leaf green style avatar for user Jeffrey Pierce
      The Consumer Price Index is figured by the Bureau of Labor Statistics in the following manner. They survey several thousand households to gain data on what goods and services they are consuming, and how much money is being spent in each of eight major categories of G&S. From this information, the BLS creates a "shopping basket" of representative goods and services and fixes its contents -- that is, these contents don't change over any short length of time, but remain constant. The BLA then figures the cost of the basket by multiplying its contents by the price of each item. A base time period of comparison is selected, and using the prices of each item in the basket from that year, the basket's base cost is calculated and assigned a value of 100. A final comparison of the cost of the basket in the current time frame to its base cost yields (usually) a different three-digit value that indicates the amount of inflation that has occurred since the base time of comparison.

      The phenomenon you're referring to is a common limitation of CPI, called quality adjustment. It does not take into account the changing value versus price of new technologies, in other words. A new smartphone or laptop may, for the same price, be twice as efficient/productive as one made just last year; yet, for CPI purposes, they're treated as the exact same good. Thus, CPI tends to exaggerate inflation slightly for this reason, as well as for a couple of others.
      (6 votes)
  • orange juice squid orange style avatar for user Ramana
    In the laptop case,(or let me say; technology), isn't deflation good?
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      Well, you could say that, but if you want to be precise, that's not really deflation, that's just a lowering of the price of a good. Deflation is a decrease in the GENERAL price level. Prices of individual goods move up and down all the time.
      (6 votes)
  • leafers ultimate style avatar for user Logan McClennan
    Is everything (that You can pay for) classified as a good the can be affected by inflation or deflation or are there some examples of good and or service that can not be affected by price changes. In my Economics class one of the teachers says there are examples that are not affected by inflation/deflation and the other one says that there are no such examples.
    (2 votes)
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    • leaf green style avatar for user Jack
      In the way that we normally think of goods and services, they are all affected by inflation. This is because we usually mean private goods and services when we say "goods and services." But there are also pure public goods, such as air, firework displays, defense, etc. that are not affected by inflation. There are also quasi-public goods that sometimes do, depending on what they are.

      So in short, all private goods are affected by inflation, but if you are talking about all goods, then there are some that are not.

      Hope that helped.
      (5 votes)
  • blobby green style avatar for user Dave Mac
    If deflation causes goods to become cheaper to buy isn't that a good thing?
    (1 vote)
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    • leaf green style avatar for user Andrew Walker
      Also, deflation is bad for those with loans (assuming it is unexpected deflation). Say you take out a loan for a house. You agree that you will pay 5% interest on that loan every year, and you signed a contract, so you can't change the rate. That 5% interest rate on paper is the nominal interest rate, and doesn't account for inflation. The real interest rate, the one that matters, is equal to (nominal interest rate - inflation), if inflation is negative (deflation), and you didn't account for it in the original rate, then you'll have to pay more "real money", or value, than you expected to pay! This can be really bad if a lot of people start to be unable to pay their debt no matter what, as it can really spiral out of control. Let me know if you have more questions or if this didn't do a good job of clearing things up!
      (3 votes)
  • purple pi purple style avatar for user Madalin Spafiu
    Can someone explain to me what stickiness of relative prices means? Thanks!
    (2 votes)
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  • blobby green style avatar for user Kevin
    Why do individuals say that deflation is bad?
    (1 vote)
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  • blobby green style avatar for user Andrey Klimenko
    After this video two questions come to mind:
    1. Why is deflation thought of as a negative concept? To me, as a consumer, this is counterintuitive

    2. Mathematically & economically speaking, the inflation/deflation can't go on forever: constant deflation would just get prices to zero, while constant inflation would result in astronomical prices eventually. So how are these two occurrence controlled? For example, in North America an average/normal inflation is 2%/year, which is same as a compound return of 2% per year. Wouldn't this constant trend result in doubling, tripling, etc. prices within a number of years? Wouldn't some kind of a 'reset' be required eventually, or would the government just keep adding zeros on the money bills to keep adjusting the purchasing power?
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      Deflation is a disaster for 3 reasons:
      1) It means that if you wait to buy something, it will cost you fewer dollars. That means everyone is going to wait as long as they can to buy things. That reduces overall economic activity and growth.
      2) People who are in debt will have to pay their debt back with dollars that are worth more than the dollars they borrowed. This destroys their wealth and increases the likelihood of defaults.
      3) Deflation means that each year, workers will need to have salary decreases. Even if you try to convince them that they are no worse off because the new dollars are worth more than the old ones, no one is going to be satisfied getting a pay cut. The result will be labor unrest and relative mispricings of labor. This is an important reason why modest amounts of inflation are viewed as desirable. The inflation greases the wheels so that relative prices and wages can be adjusted without necessarily cutting nominal prices and wages.

      Constant deflation COULD go on forever, just like you can keep cutting a number by 2% and never reach zero. In practice it does not go on forever because it causes so much economic pain that the government and/or central bank will do whatever is necessary to combat it.

      Constant inflation can go on forever, and prices just rise and rise. Older people think the prices of some things ARE astronomical compared to when they were little. Prices do double and triple and quadruple over long periods of time. A penny used to buy you something, now it is basically worthless. When ATM's first came out, you could ask for multiples of $10, but now you can only get $20, and some of the machines are starting to dispense $50 bills. In countries where inflation has been very fast, yes, they just add zeros to the currency, or eventually issue a new currency that is worth some multiple of the old one.

      The US has basically had non-stop inflation for the last 50 or 60 years, usually low single digits but not always. Prior to 1933, when the US was on a gold standard that force prices to remain relatively constant, we had periods of deflation to offset periods of inflation. Recessions were much more common and severe. This is one reason why no economists support a return to a gold standard.
      (3 votes)
  • duskpin ultimate style avatar for user tuannb1997
    As Inflation is often associated with Low Unemployment and Economic Growth, is Deflation - it's counterpart - related to High Unemployment and Economic Stagnation ? Also, can you list some reasons why economists generally dislike Deflation ?
    (1 vote)
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    • purple pi purple style avatar for user Peter
      Inflation can generally be controlled by increasing the cost of credit (the Central Bank raises interest rates/discount rates).
      Tax rises can also be used, but that gets messy, and requires a lot of tinkering with business calculations etc. And folks think that tax rises are an attempt by the Government to take money, rather than an attempt to control inflation.
      Deflation is more difficult. As the case of Japan, and more recently Europe, has shown, what do you do when interest rates get to zero?
      Tax cuts are a maybe, but folks will complain when the rates go back to "normal". Also tax cuts give more money to folks with money, which can be unpopular.
      So, Central Banks like modest inflation, because they feel they can control the money supply with changes in the interest/discount rate, and they don't like deflation because they are not sure about how to control it.
      (2 votes)

Video transcript

Deflation is literally just a lowering of prices, or a general decrease in the level of prices for goods and services. Or another way to think about it, since inflation is an increase in the level of prices, you can just view it as negative inflation. And so, let's say we're the folks at the Bureau of Labor Statistics, and we're trying to compute the CPI index. And in one period-- let's call this period one over here-- we have our CPI index for urban consumers. And that's the one that's quoted most often. And we have this basket of goods. And it'll have housing in it. Let me write that a little bit neater. It'll have housing in it. It'll have transportation in it. It'll have a fuel in it. It might have some proxy for entertainment or whatever else inside of it. And that basket of goods, let's say in period one-- and this is a simplification-- runs that urban consumer on average $100. And then we go to period two, and we look at that same basket of goods. Maybe we're adjusting certain things, maybe some products have become obsolete and we have to replace, or there has to be some adjustments for technology. And that's all under debate, how you should adjust them. But given that, assuming everything else is equal, that same basket of goods is now running at $98. And so the total cost of goods and services for this kind of average consumer has gone down by $2. Or we could say that we've experienced negative 2% inflation, which is really just another way of saying that we have experienced deflation. Now, deflation is not the norm, especially for growing economies, the way that our current economic systems runs, although it does happen. And Japan in particular is probably the most recent, most famous case of deflation. And the main reason why economists really don't like deflation-- or I should say in particular, while central bankers really don't like deflation-- is that it makes it much harder to control the economy or to fuel the economy with interest rates alone, or actually just with printing money alone. And I'll go into a little bit more depth with that in future videos. One thing I do want to make clear is although deflation isn't what we normally see in the broader economy as a whole, it does happen very frequently in specific sectors. And the most common one is in the technology sector, specifically hardware. We've all experienced buying a laptop at one period-- so right now you buy the laptop for maybe $1,000-- and then six months later you see that exact same laptop for $500. And that's just because the rate of technological innovation is going so fast that they can produce the same amount of memory and processing power for a lot cheaper now. Or for the same amount of money you can get much more memory and processing power, and all of the rest. And you see this with laptops and with a big screen TVs and phones and all the rest.