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Moderate inflation in a good economy

Moderate amounts of inflation are common in healthy economies, so some inflation may actually be a good sign. Learn why in this video. Created by Sal Khan.

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  • leaf red style avatar for user Ronald Chang
    Can someone please explain why in the late 19th century and early 20th century, we had high growth in the economy but experienced deflation? I'm trying to figure out why prices ever need to go up at all. Would an economy be sustainable on deflation?
    (21 votes)
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    • leaf green style avatar for user Aeon_Of_Khan
      Douglas: To counter your claim, here is an explanation. You have production capacity, and demand. When production capacity meets the demand, you have optimal productivity: money goes into the system proportionally to how much is needed to satisfy demand. But nature leads all living organism to reduce waste of energy in order to increase survival rate. So on the production-end, there is constant optimization in order to reduce expenditures, which leads to short-term investments needed to optimize production (expenditures = risk, so there is always a desire to reduce risk over the long term by increasing expenditures over the short term, just like an animal will spend energy now to feed itself, in order to reduce the risk of dying from starvation later). This leads to an increase in the money going into the system, which, in a world where the currency would be back by a commodity, would NOT be possible without acquiring more of the commodity in question, potentially limiting optimization if money is not available to invest if the commodity supply did not expand.

      In our current system, money can be printed and then borrowed to invest in production optimization. This leads to an increase in the money supply, and deflates the value of the currency by a proportional amount. But once production is optimized, less money is needed to keep the system operational. Yet the money spent to optimize the production remains in circulation. This leads to an excess in the money supply VS production capacity: there is now more money in the system than before. This means people have more money, and this leads to a desire to spend said money, which raises demand. Since demand is higher, prices can be increased to collect the excess money, and reduce to a minimum the amount of money requested through borrowing to increase production capacity to meet the new higher level of demand, but logically there is still a need to borrow some money to increase production capacity, hence even more money goes into the system. This goes on in a loop. Let's not forget that in real terms, as the above is simplified, wages increase too. This is why a bag of chips costs more today: there is more money in the system, but there reason for that is simply because there has been growth over the decades.

      So inflation is perfectly normal for an economic system based on growth. Production capacity is constantly optimized, which leads to more money in the system than there was previously, which leads to higher demand, which leads to higher prices and the need for more money to increase production capacity, and then optimize it once more, and this leads to more money in the system again.

      This is evolution, it works no differently in the animal kingdom.

      Basically, the "value of money" today is simply an indicator of growth, by comparing it to the past value of money. It is not "things are more expensive". It simply indicates that there was a need for more money to be spent over time in order to meet increase demand, which are both self-feeding loops: the nature of a growth economy.
      (12 votes)
  • leafers ultimate style avatar for user Raphael
    Then what thing in that loop is going wrong?in the U.S. prices are going UP not staying in a loop like that.
    (7 votes)
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    • blobby green style avatar for user Adam Levy
      I think what's important to look at here is the value of money. This video presents a very one sided view of the economy. I do not mean that it is over simplified, I mean that there are other ideas about inflation and where it comes from that are not presented in this video. When we talk about inflation we are talking about the value of money. Where does money get its value. In a way, our dollar gets its value because you have to pay your taxes in dollars. The Federal Reserve issues money to banks and they loan it out to lesser banks at a small interest rate. The lesser banks then loan it out to individuals and businesses. When a bank creates a loan. It does not physically move any money around. In fact the bank doesn't actually have all the money in people's accounts at any given time. So when a bank gives a loan it justs credits the money to an account. The bank doesn't take it from somewhere else though. It creates it out of thin air. The bank is required by law to keep a certain amount of money physically in the bank all times. This is called the fractional reserve banking system. In the event of a run on the bank, the bigger national banks will bleed funds to the lower banks to cover the losses. The Federal Reserve insures the money in the bigger banks. This is intended to keep the economy stable. But like any well intentioned policy, there are unintended consequences. Consider what gives the dollar value. It used to represent gold. Now, however it is backed by the full faith and credit of the United States of America. Which means that your dollar is good until you no longer have to use it to pay the government. However, how do we know what one dollar is worth? The value changes a little bit every day, but how do we know? What determines the value of a dollar is what determines any other price in an economy. Supply and Demand. When supply increases the value of the dollar drops. Not only does the value of everyone's dollar diminish slightly when the money supply increases but the interest rates on loan decrease too. Interest rates are the price of having money now instead of later. In any other part of the economy, when prices are artificially held too low or too high you either have a shortage or a surplus. In other words, when prices are distorted artificially, you get a misallocation of resources in the market. Prices give people information to make decisions. When people have bad information, they make rational decisions that end up having negative consequences. For example, when interest rates are too low, projects and investments that previously seemed unprofitable, suddenly appear like sound ventures. Later down the road however, entrepreneurs may discover that the economy (a form of unplanned social organization in response to scarcity, self interest and peaceful interaction) that the profits simply aren't there to support their investment. When enough of this misallocation of resources occur for too long, the price bubble bursts and prices must correct themselves back to rates closer to equilibrium. Surprisingly, price bubbles are constantly occurring. Whenever a consumer or producer seeks to buy or sell a product, they can only ever guess at the price. The laws of supply and demand push prices toward equilibrium but sense demand cannot be quantified and is constantly changing, prices are only ever an approximation. Bubbles resulting in mis-speculation burst all the time. Thats why the graph of a stock's price is not a smooth and predictable line but a seemingly random series of ups and down. This is the price mechanism at work. When it is allowed to happen freely, the bursting bubbles go unnoticed and the economy continues to run smoothly. However, when prices are distorted, these bubbles can become sustained and get bigger. Prices get further and further away from equilibrium and resources get moved around and allocated the wrong way. Finally when the crash hits, it takes a long time to turn the economy around and reallocate resources. If we want to talk about inflation. We need to first understand where the value of money comes from.
      (31 votes)
  • spunky sam blue style avatar for user Thiago Felizali Bruzadelli
    When Sal drew a negative link between supply and prices I got i little confused since the supply curve gives us a positive relation between this two variables. Can someone please clarify this for me? Is it a matter of short / long term?
    (6 votes)
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    • blobby green style avatar for user Philipp
      Think about it this way: If supply goes up, there will be more competetion between the suppliers. This competetion leads to lower prices.
      An example: Farmer A is the only farmer in your town. But all of a sudden, another farmer, farmer B, sells his apples in your town. Now you can chose whose apples you are going to buy and both of the farmers know that. That's why farmer A now offers you his apples at 5 % less to make you buy his apples. Now, only because farmer B moved to your town, you are saving 5 % on apples, or, in other words, the price of apples decreased by 5 %.
      (15 votes)
  • blobby green style avatar for user jtjones6
    Would an increase in minimum wage increase inflation as well eventually?
    (3 votes)
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    • blobby green style avatar for user Dave
      I almost said no, but maybe a little. Most people on minimum wage are either poor or young or both. Poor people of all ages tend to have very high marginal propensities to consume because there's very little choice to save money when bills eat it all, and when they do get an extra dollar they're probably going to enjoy it because they're consumption starved already. Young people would also likely have very high MPCs because they're not freaking out about retirement yet. So to the extent that the minimum wage transfers money from the rich to the poor (and isn't eaten up by extra unemployment in the unskilled labor market), it would create a little extra demand which could cause some inflation.

      So a lot of ifs, but maybe a little.
      Would that translate into a persistently higher rate of inflation? Nothing the Fed can't handle.
      (4 votes)
  • spunky sam blue style avatar for user wowsk
    Why if the economy is good would it ever become bad? It seems like it is a loop that just keeps going. Am I missing something?
    (3 votes)
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  • blobby green style avatar for user Donal Jackson
    could the economy be good without inflation?
    (3 votes)
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    • blobby green style avatar for user Justin Crouch
      Asking if something is "good" isn't the proper way to approach a topic in economics. What is "good" for one person isn't "good" for another. A better way to ask the question would be, "Can GDP increase without inflation?", or "Can unemployment decrease without inflation?" I hope this doesn't come off as nit-picky, but a poorly phrased question will get bad answers.
      (3 votes)
  • male robot hal style avatar for user William E. Cormier
    At , instead of linking directly to Employment wouldn't Profit lead to more Investment which could then lead to more Employment? For example, if a company relied mainly on machines to produce its goods, then their profit would lead them to investing in more machines which could then cause the company to hire a few more people to manage them.
    (3 votes)
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  • duskpin ultimate style avatar for user Jackson Frankfurt
    What exactly is meant by a "good economy?"
    Does this simply mean high standard of living?
    (2 votes)
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  • mr pants pink style avatar for user Prithak Mendiratta
    In this video, at around , it shows that the demand will increase with increase of employment and wages, but I didn't understand how.
    (2 votes)
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    • leaf green style avatar for user Vasim Patel
      More people with jobs and higher wages will consume more products and services.
      Example: If you get a good-paying job, you might buy a new car or plan a trip, or have dinner with GF at a good restarent.
      All these things will result in more demand as you have money in your hand you'll spend it somewhere resulting in more demand for goods and services.
      (1 vote)
  • blobby green style avatar for user sshrutisoumyasmiles
    From to , I did not get how utilization and investment are being related?
    (1 vote)
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    • duskpin ultimate style avatar for user Exponentially Radical
      Utilization: When the machine is used 16 hours per day instead of just 8, you get more use out of the machine, before a newer product makes it obsolete. Profit: When you get more out of your machines, you have higher profits. Investment: When you have higher profits, there is likely to be more investment in your industry (perhaps you want to grow your profitable business or perhaps other people see your profits and elect to enter your industry as your competitors).
      (2 votes)

Video transcript

Any economy is a super complicated thing So what I am going to do in this video is a super over simplification. But it is just a way of thinking about things. In particular, I want to think about why good economies tend to be associated with a moderate level of inflation. And that will also help inform us when we are thinking about Stagflation when we have inflation with a bad economy. So, a good economy, employment is up And because employment is up, employees have more negotiating power There's more people who want to hire them, there is fewer people who wants their jobs, And so wages will go up. And since you have more people with jobs, And those who have jobs are being paid more, You can imagine that demand will also go up. There is more people that have money in their pockets. And if demand goes up, Then companies, or you can think of them as factories, But it can also be services, Then everything will be utilized more. And if things are utilized more, Then the companies or those factories or whatever you want to think of them, They are going to have more profit. On top of that, if they get close to fully utilization, Or if they see that fully utilization is down the road, They are going to want to invest more. And, they could actually push off that utilization and get more profit, by maybe raising prices. So this is where that moderate of inflation, really shows up. The fact that there is more demand, the fact that you can produce a little bit more, and it could raise prices a little bit more. So this is where, the moderate level of inflation shows up. And there is a little bit of a negative feedback, if price goes up. It will inhibit demand a little bit. And that is why it is moderate inflation, not some type of crazy inflationary spiral here. But the net effect of more utilization, and more investment is going to be an increase in supply. is going to be an increase in supply. And once again, And this is kind of e-con 101, If supply goes up, price will also have an inhibitory impact on price. So let me draw, so we get all the feedback loops here. So this is negative feedback right over there. But to complete the loop, if we are investing more, we are going to build more factories. or some more capacity to do services or whatever else. That is going to increase employment. If we have more profit, Then a company feels better about growing, It feels more like it have a cushion, and feels more optimistic about the future, that is going to help employment. And obviously, utilization itself if we want to run the factory lines longer, we are going to need more people to run those lines. So that will also increase employment. This is like the general feedback loop you can add little nuanced twists to this, but this is the general idea of a why a moderate level of inflation is kind of associated with this virtuous cycle you normally see in a good economy.