Deflation despite increases in money supply | Inflation | Finance & Capital Markets | Khan Academy

Deflation despite increases in money supply | Inflation | Finance & Capital Markets | Khan Academy


Let’s revisit the island
or the universe that only has a farmer and a builder in it. Let’s think about a different scenario. Let’s think about a
scenario where they each start off with a lot of physical currency. We’re in a universe that’s
starts off with much more physical currency
than the last example. Where the universe had only 4 gold coins. Let’s say that the farmer
right over here starts off with … and I’ll right down
the number instead of drawing the coins. Actually let
me draw the coins, that’s kind of fun. Let’s say
he starts off with 5 gold coins, and the builder
also starts off with 5 gold coins. Entering into this year,
the farmer is feeling pretty pessimistic. He
goes to the builder. He tells builder look I
just want the base level of construction or maintenance or whatever going on in my farm
today. I can only afford 1 coin of business from
you, or what you can do for 1 coin. He gives
that coin to the builder. The builders feeling pretty pessimistic. Normally the farmer
starts off the year much better than that. He says
that this clearly going to be a bad year. I’m
only going to buy my base necessities for food. He goes to the farmer
and says look even though I have … he’s not
going to tell the farmer that he’s hoarding all of his cash. He’s going to say look
farmer, things are bad, business is bad, I’m
preparing for the worse. Just give me the base
minimum, cheapest, simplest, food you can that’ll keep me alive. So, he only gives 1
coin back to the farmer. Imagine that the money
supply actually increases. For whatever reason the
farmer digs around in his backyard and finds some more gold. Then the builder, also,
while building a building actually discovers a
huge chest of gold right over here. Their still
feeling pretty pessimistic. Maybe their just pessimistic people. The farmer despite this
increase in the money supply, this gold that he discovers. He’s like how frequently
am I 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. It was even worse last year then it normally is. I’m going to spend as little as possible. I’m going to go to the
builder, and I’m going to say look things seem
to only be getting worse. I can only afford half
a coin worth of what you have to offer, before
this base maintenance. The builders thinking
gee. 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 for that half of a coin. He does it, and essentially,
his price had gone down despite the fact
there’s more currency. 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 in absolute gold coins now. When
he goes to the farmer. he’s like, I have to buy that base level food. Otherwise, my
family’s going to starve. Business is worse than
ever. I’m so pessimistic. He doesn’t even tell the farmer that he discovered all of this. That he’s hoarding all of this. So, he’s
say farmer, i can just afford half a coin worth of stuff. The farmer says well I guess so, since the building prices have
gone down, and I can buy more with that half of
coin. I have all this surplus labor, and surplus
capacity on my farm. Sure, I will take a half
of coin for the same thing last year I took a full coin for. You see the situation where
deflation is occurring even though the money supply has increase. Of course, I’m exaggerating things. In normally if you have
this large of bonanza, and the money supply,
people would start to get optimistic and would start to spend money. It would probably lead to deflation. 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 are confidence and what confidence drives, and that’s specifically
the velocity of money. The transactions of money. The higher the velocity … or quantity
matters. But quantity times velocity what really
drives the level of prices.

25 thoughts on “Deflation despite increases in money supply | Inflation | Finance & Capital Markets | Khan Academy

  1. Why do investors invest more/customers spend more? *shrugs* who knows.. they must be optimistic!
    Why do people hang on to their purchasing power? *shrugs* Who knows .. they must be pessimistic! Damn them hoarders!.. saving for tomorrow? What a bunch of nonsense! Why can't they all be blowing all their money on hookers and beer?

    Damn stupid investors/customers/people, why cant they live in the moment? They are ALL a bunch of loony bipolar pyschos!
    Except Keynes.. he was "smart".

  2. The problem with your explaination is, gold requires effort to mine and refine. Why would the characters place any value in gold? The current deflation we are experiencing is limited to certain assets such as housing that were wildly overvalued. I'm not seeing any fuel or food deflation. Money only has real value if its creation is a result of human effort. If money is simply printed, it's fucking stealing, PERIOD! Would anyone accept FRNs if we weren't forced to by law?

  3. @rmstorms The point in this example is that the money supply increases, not by what means it increases or what kind of money, gold, paper, bitcoins they use….

  4. @NotTheLaw
    You mean the ORIGINAL definitions? Like deflation means decrease in money supply, not falling prices.

  5. If the economy is going well, lets say positive growth of 5% and 1% more money is printed then we should get falling prices (what you mainstream's call deflation). I don't see what is so strange about that.

    If all people in the world expect bad things in the future then they are probably correct. If productivity is to be lower then it is a good thing that people use less resources or else there will not be enough to go round. The market works.

  6. Well, as I'm sure you know Sal, this is a controversial area. I suppose I agree that you can *temporarily* have deflation and an increasing money supply at the same time, but IN THE LONG RUN, there will always be rampant inflation after everyone regains their optimism. That inflation will be at whatever level is necessary to reflect the "new total quantity" of money in the system.

    What you have really explained here, Sal, is how the market can be temporarily distorted.

  7. @rmstorms No I turn all of my money into goods, instead of putting it in a savings account I go down and buy silver…

  8. @mrhnm And that is why the first act of Congress was to define the metal weight of a dollar in silver and gold. Silver is real money. It's value is the result of effort. In the situation described in this video, gold wouldn't necessarily have value. There are only 2 parties.

  9. @rmstorms Yep, silver compensates for the inflation of the fiat system. Because it is actually something as opposed to magic money…

    "There are only 2 parties" What pray tell are you talking about?

  10. People don't bury money in the ground, they look for a return on their investment. IN GOOD TIMES, PRICES SHOULD GO DOWN because more things are produced. In bad times, less things are produced, so prices go up. AND IN THE LONG RUN, PRICES SHOULD GO DOWN, as we get better at making things. Of course we haven't seen the benefits of falling prices because the Fed prints too much money and causes inflation. The inflation tax steals value from your bank account without you knowing it.

  11. This example illustrates: deflation in accepted exchange value, but the value of gold it self has not gone down at all since confidence in its acceptance as an exchange token has not gone down at all. As you alluded to confidence in a currency/money is what determines its purchasing power/value. So what is keeping people confident in the US Dollar is beyond me. We should all stack out gold and silver since this rarely loses purchasing power.

  12. This is crap. It doesn't take into consideration of supply and demand. Such situation can only happen in a fully unionized system. I'd like to see that happen one day.

  13. This is my biggest turn off of Keynesian economics. They think they understand the public response to monetary policy

  14. technology is deflationary, QE is just helping to create a little bit of inflation. simple example is this video on youtube is free. you know a decade ago we must pay for this. music is free on youtube, i remember buying a cassette tape back in the day. internet cost is dropping every year. free games, free app. i remember buying a nintendo cartridge and at that time it cost a lot. now i can just play dota 2 for free. remember encyclopedia? who the hell buy that now days. instead wikipedia is free. phone is so cheap now with a lot more power and sensors inside.

    fracking technology for oil is making oil cheaper. and some nation trying to keep the price up by dropping the production. well technology wins all the time. tech is going efficient every year. so good luck cutting that production down. everything technology touch is going down in price.

    we are going to a deflationary economy. and the government better keep those QE going. or else no inflation.

  15. Anyone can create a hypothetical situation to suit a particular model. How about show the real evidence like what Milton Friedman did with how money and price are correlated OVER TIME applying MV = PQ. He showed how money supply and price will reach equilibrium within 2 years for over 5 countries (Japan, Brazil, United States, United Kingdom, and Germany) he studied. The price equilibrium does not change over night, it takes less than 24 months to take effect.

  16. So the entire defationary cycle, at its core, is nothing more than the product of a belief. And so too an expansionary credit cycle and booming economy….

    The money and FOPs are there, people just don't want to deploy them or trade.
    It seems like things would be better if people could make direct barter deals between each other. Or large, simultaneous promises between multiple people.

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