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Course: Finance and capital markets > Unit 3
Lesson 4: Capacity utilization and inflationInflation, deflation, and capacity utilization
Inflation is associated with an increase in output driven by an increase in aggregate demand, but an overlooked aspect of inflation is the role of capacity utilization. In this video we explore some patters associated with capacity utilization, inflation, and deflation. Created by Sal Khan.
Want to join the conversation?
- Which is better, Inflation or Deflation?(15 votes)
- @ JeffAxelson - when you say: "can be generally be avoided by proper central bank tools & responsible fiscal policy" -when has either of those two "generally" happened? For the most part it seems the avarice of the government & Fed have have shown they are incapable of using central bank tools properly or being responsible with fiscal policy. All one has to do is look at the current economic situation in the EU & US as proof. That's why Austrian economics is good because it leaves the supply/demand up to the natural market forces(8 votes)
- Why isn't the definition of inflation the creation of money or an increase in the money supply?(9 votes)
- When you inflate you increase. Increasing the monitory supply is inflation. Other things like increases in prices and decreases in purchasing power are the symptoms of inflation.(5 votes)
- Is it correct to say that Sal's point of view is the keynesian one? Money, in his model, is endogenous, and the FED can't control it. If it increases the supply of notes (M0), and if people don't want to spend it (liquidity trap), the velocity of money will go down to compensate the increase in the quantity of notes. The neoclassical theory, on the contrary, thinks that money is exogenous, that FED controls the quantity of money. Inflation, is Sal's view, is not a monetary fenomenon.Is it right?(4 votes)
- This depends on what school of Keynesianism Sal follows. The Neo and Post Keynesians (Harrod, Hicks, Solow, Samuelson, Minsky) believed money to be endogenous (the LM curve being constant) and that supply and demand to be the chief cause of inflation. However, with the rise of rational expectations theory and monetarism school, New-Keynesianism came about. New-Keynesianism agrees with Milton Friedman's famous quote: "inflation, is always and everyone a monetary phenomenon", and postulates that the money supply is exogenous. However, market failures can still lead to liquidity traps. Members of the New-Keynesianism school include Ben Bernanke, Janet Yellen, Olivier Blanchard, Kenneth Rogoff, Paul Krugman (to an extent), John Taylor, and Greg Mankiw. Therefore, Sal's analysis is still Keynesian, depending on the school.
Cheers(5 votes)
- After watching this video I wonder if we may be confusing correlation for causation?
The graphs show how increases in capacity utilization mostly precede inflation, but that doesn't mean necessarily that utilization is causing inflation, it just shows a correlation between them.
May there be another underlying factor, like access to cheap consumer credit, or low interest rates on savings, that increase consumer demand / spending, which in turn increases utilization AND causes inflation?(6 votes)- if you increase the money supply (which the central bank controls) the interest goes down and demand goes up. Inflation goes up because of the increased money supply and because of the increased demand.
So yes, there are other factors but that doesn't chance the point he is trying to make that capacity utilization leads to inflation (keeping other factors constant).(1 vote)
- Wouldn't make more sense, when your service has a low utilization, for you to maintain your prices, and improve its efficiency? For example, make less cupcakes and work on selling it all, so you spend less and wins enough.
I don't really understand why low utilization alone would lead to a decision to make prices cheaper -- what would probably make it more difficult to improve the service.
Probably, improving the efficiency or quality of the service/product would make more sense, right?(3 votes)- Yes, but you're thinking logically, with no bean-counters telling you what to do, and you're thinking about the better good of everyone. Rather than being greedy, if you were to increase the quality of your products, in the end, you would seel more, people would be happier with your product, and you could still sell everything at a much lower price.(3 votes)
- Why would capacity utilisation increase inflation? Shouldn't it decrease?(3 votes)
- When the utilization is high the businesses must raise prices to make more money so it cost more to get the same goods and services which is inflation.(3 votes)
- I'm not sure why around6:15Sal says that increases in capacity precede increases in inflation, but then at7:00ish measures the capacity at the same time as the inflation upturn to say "this is the threshold utilisation which causes inflation to rise" - surely a) you'd be accounting for that lag and b) any increase in utilisation ought to correspond with an increase in inflation?
Also, the end of the timeline doesn't seem to be in keeping with this idea - the inflation rate doesn't seem to have much at all to do with the utilisation. Could someone expand on this?(3 votes) - How can the over printing of money create deflation?(2 votes)
- Seems Sal is self-conflicted here. At2:24, He assumes that if the capacity utilization is high, then the factory owner would be more willing to raise the price of cupcake than to produce more cupcakes, because he can make profits by namely doing nothing.
However, at3:31, Sal gives us a different claim that if the prices go up, it will make people want to add more capacity.
I am confused again. How to explain this? Thanks.(1 vote)- That's the short run versus the long run. In the short run, prices go up, because capacity can't be added. In the long run, capacity can grow, and prices reflect the long run cost of that marginal supply.(2 votes)
- And what happened in the 90s when capacity utilization was high but inflation went down? Just to know!(1 vote)
Video transcript
With all the talk of the
deficits that we're entering, and the stimulus bill, and all
the money that's being spent on the bank bailouts, and
potentially the auto bailouts, the question that everyone's
asking: Is this going to lead to inflation? And that is what I hope to
address in this video. And I guess a good starting
point is, well, what is inflation? It's a general increase in the
prices of goods and services. So they actually measure it
by-- they take a basket of goods and services and they see
how those prices compare to a reference year. And if those prices go up by 3%,
they might use a consumer price index. They'll say inflation
increased by 3%. So that's what's inflation. And the opposite of inflation,
if things actually get cheaper, is deflation. If one year 10 megabytes of RAM
costs x dollars, and then the next year, it costs a little
bit less, it's actually a deflationary process, at
least in that market. So without the those definitions
out of the way, let's talk a little bit
about what causes it. A couple of days ago, I made
these videos on cupcake economics, where I talked about
what happens when the cupcake factories have high
utilization or low utilization. What might happen with prices? And the reason why I did that
is because I really want to make it very clear that it
really is utilization of factories or of people
that drive prices. Let's say this is all the
capacity that I have. When I talk about capacity in this
video, I'm speaking in very general terms. It's all of the
goods and services that we could produce. We could just talk about labor
capacity, and then unemployment rate is a measure
of what is essentially not being utilized. But this is just our capacity,
our productive capacity. And in those cupcake economics
videos, I showed that if the demand is pushing up against
capacity-- let me do demand in a different color. If demand is really close
to capacity-- and I know everything I draw kind of looks
like balance sheets, but this isn't intended to
be a balance sheet. This is intended just to show
you that demand is pushing up against capacity. So in this situation, let's
say, this is capacity. If demand is at 90% of capacity,
then the people with the capacity might say, gee,
instead of trying to just try to sell that extra unit-- this
is demand-- instead of just trying to sell that extra unit
and have to worry about all the raw materials and have to
work for that extra unit, why don't I just raise
prices, right? So high utilization of capacity,
it leads to prices increasing. And this isn't some kind of
fancy macroeconomic principal; it's true if you're running
a lemonade stand. If all of a sudden, you're
starting to sell 95% of your lemonade, you'll probably say,
hey, maybe it's worth it if I raise the price. On the other hand, low
utilization-- let me pick another color --will lead
the prices dropping. And you go back to your lemonade
stand, and you say, wow, if I'm only selling 20% of
the lemonade that I make, maybe my problem is that my
lemonade's too expensive. And frankly, if there was a
bunch of lemonade stands, everyone is trying to
sell their capacity. So just to compete
with each other, they'll all lower prices. Actually, I'll throw another
thing in here that's a little unrelated to inflation, but high
utilization makes prices go up and it also makes
people want to add more capacity, right? So also investment goes up. Both of those things do add more
capacity, but we won't worry about that right now. So if you accept that-- and
I think it's a reasonable argument, because it's really
based on common sense things --then I think you'll buy the
argument that, if you have very low utilization, it's
difficult to have inflation. And, likewise, if you have very
high utilization, it's hard to avoid inflation. And to kind of hit the point
home, actually, I took our company's Bloomberg terminal
and copied and pasted these charts here. And the orange-- and I know you
can't see it that well on YouTube , so I'll try to make
it clear in my drawing, I'll do it the same color, --this
orange shows capacity utilization, and the starting
date right here, I think it was 1967. This is 1969, actually December
31, 1969, so this is 1970, beginning of 1970, this
is beginning of 1980, beginning of 1990,
this is 2000. This orange line represents
capacity utilization. So up here this is 90%
utilization and then down here this is 70% utilization. So if we look here, in the late
60's, we have very high utilization. Arguably because of the Vietnam
War, we had factories running at capacity to build
bombs and Agent Orange and God knows what else. And then utilization
went down. We could talk a lot about the
history, but, in general, the interesting thing-- well,
actually, before I go into what happened, let's think about
what this white line is. So the orange line
is utilization. Up here we had like
90% utilization. Very recently, this was like
2007, we had 80%, and very recently, utilization has
dropped off, which essentially just means we're not running
our factories at full tilt. This white line is
year-over-year inflation growth, and let me
do that in white. This is year-over-year
inflation growth. Actually, let me draw a zero
line, so you can separate inflation from deflation. Let me see, zero inflation
is right over here. That's zero inflation. And you see, in the time series
that I've done, we've never had zero inflation,
although we have had periods of a very high inflation. But the interesting thing, just
falling into the cupcake economics and this whole
notion of capacity utilization, is that
inflationary periods are always preceded, at least all
the data I have, by increases in capacity utilization. So you could view this as the
beginning of a pretty significant uptick
in prices, right? And notice, it was preceded
by an uptick in capacity utilization. So, if you saw right here, wow,
capacity utilization is starting to go up-- and
actually, another interesting thing is to see what threshold
of utilization starts to trigger inflation. So over here, you say, OK, when
inflation really started turning around, we were at
a capacity utilization of roughly 83%, 84% right there. And then, if you look at the
next period where inflation really started to hit-- you can
either pick that point or that point --where was
capacity utilization? It was around that same level
that was right there. It was above 80. This was about 82%. And we could pick every
period before that. Well, since then, inflation
really hasn't been a major problem. These are our two major bouts
of inflation, in the early 70's and in the early 80's,
and those were when we had extremely high capacity
utilization. So the point I want to make here
is capacity utilization really is the driver
of inflation. You actually could find it
the other way around. So this white line here, you
don't see it because the orange line-- actually, I
realize that I'm showing you off of the screen. Let me actually reduce my
window, so I can show you. So this is more recent, where
we see that capacity utilization started
falling off. I think this is in the
summer of 2007. And you don't see it there
because it's overwritten, but the inflation line has also
dropped considerably. It comes down to here. But notice once again, although
here it's pretty close, but utilization dropped
off a couple of quarters before inflation dropped off. And that's why I always wonder
why the Federal Reserve Board of Governors, they always talk
about different inflation indicators and what to do about
interest rates, when you do have a pretty good indicator,
and that's capacity utilization. The next question that everyone
has is, OK fine, Sal. Capacity utilization
drives inflation. We can all buy that. But clearly, what's going on
right now is just a wholesale printing of money. And won't the wholesale printing
of money drive demand to go up, and then we'll
have very high capacity utilization, and then we'll
have inflation or even hyper-inflation? And my argument there is that's
normally the case. Normally, if you increase the
money supply, if the money supply goes up, that should
increase demand. But there's a subtle, and it's
almost a philosophical point, but it's an important one, to
realize: Money just allows you to express demand. Let's say I really, really want
to buy a Rolls Royce, I just don't have the money. If someone gave me $200,000 into
my pocket, then I could express that demand to
buy the Rolls Royce. On the other hand, let's say,
I have everything I need. I'm happy with my Honda and my
two-bedroom apartment, and someone gave me $200,000. So they've increased, at
least, my money supply. Will that increase the demand
for the Rolls Royce? No. I have money to express the
demand, but I won't do it, because I don't think
it's necessary. So you can make that same
analogy in the economy as a whole, where you can imagine
an island where, let's say, there's five of us or three of
us, because I don't want to draw five people. And between us, we use seashells
as a currency. And we're very confident. And maybe I'm the builder, and
this guy's the fisherman, and she's the farmer. Let's say in one year I use a
seashell to get some fish. And then he uses that seashell
to buy some crops. Then she uses that seashell
to buy a house. And I use that seashell again
to buy more fish. You can see that one seashell,
even though my money supply on that island is one seashell,
it can transact many times in that year. So the velocity in this
example is very high. So you notice that my expression
of demand happens in these actual transactions. I'll do a classic money
supply equation soon. But you could imagine another
reality, where, for some reason, I stop trusting
this guy. I've become very cautious, and
I say, well, you know what? I don't want to give him my
seashell, because I'm not sure if I'm going to get that
seashell back again to do something else. So you can imagine a reality
where the central bank of our island, all of a sudden, they
find hundreds of seashells. And they put seashells in
everyone's pockets so we're all full of seashells. But all of us have lost so
much confidence in the economy, or are so unsure over
whether other people are going to use my goods and services,
that I don't want to use their goods and services. So we all just start
hoarding seashells. So this is a situation where
the money supply could actually increase pretty
substantially, but since no one wants to express it through
demand, it's not going to increase utilization. And so in the situation that
we're in right now, if you're wondering about whether you're
going to see inflation or deflation, my argument is look
at capacity utilization. People can point to
the money supply. This is a classic money
supply equation. The money supply times the
velocity of money-- that's how often the actual dollars switch
hands --is equal to the price of the average price of
goods times the total quantity of goods and services we have. So most people say, wow, if the
money supply increases, then won't prices increase? Well, that would be true if you
assume that velocity and quantity are constant. But we're saying that whenever
you have major shocks and people lose confidence, this
velocity can slow down considerably, especially when
things like financial intermediaries start hoarding
money and people start putting money into their mattresses. In fact, oftentimes, people
don't even consider things that aren't being transacted
money. For example, those commemorative
coins that they sell on TV. They're not considered part of
the money supply, because people don't use
them as money. Anyway, I'm all out of time. I'll continue this discussion
in the next video.