Inflation dynamics

0:00- [Narrator] So let's discuss inflation a bit. You might already be familiar with the idea. It's essentially the idea of prices generally going up, they're inflating. You can imagine an expanding balloon that represents prices. That's why they use the word inflate or inflation.

0:19Now, what's the implication? Well, if prices are going up, that makes things more expensive. More expensive. Or another way to think about it. If your wages or the amount of money you have isn't keeping up with that, you might not be able to buy as much, so you buy less.

0:40And that actually already touches on one of the dynamics of inflation. One theory is that you have a wage price spiral in certain cases. And it's not just a theory. People have actually observed this. That prices go up. Prices go up. And then workers in order to be able to afford those higher prices expect higher wages.

1:06Higher wages. And then those higher wages drive prices even higher because that is one of the inputs of production. Now, there's many other potential causes of inflation, and it's usually a mixture of many, many different things. But to understand that more, we could, very straightforward, but to understand that more we could look at aggregate supply and aggregate demand.

1:34So let's say on these horizontal axis right over here we have aggregate output, which could be something like real GDP or something like that, if you can see it. So aggregate output. And then on this axis, we're talking about aggregate price levels. So it's everything in the economy, or a basket of goods, price level.

2:03And we could think about aggregate supply. So at a high price, people are going to want to supply a lot. At a low price, people are not going to want to supply as much. So this is aggregate supply. And some people would call this short-run aggregate supply. We don't have to go into that right now.

2:24So let's call that aggregate supply. And aggregate demand goes the other way. At a high price, people aren't going to want much output. And then as prices come down, people are going to want more and more output. Aggregate demand. So if we see a situation where prices go up for things, so one way to interpret that is, well, that includes the inputs into production.

2:52So we could call that cost push inflation. So for a given level of output, it's to cost more in order to produce it. So you could view that as a shifting up of the aggregate supply curve. And if you have a shifting up of the aggregate supply curve, then what are you going to see?

3:09You're gonna see a new equilibrium, higher level of price. This was the old level of price. This is the new one. Prices went up. That is inflation. It's interesting that you also see, at least in this very simple model right over here, the aggregate output going down.

3:25And that's because maybe people can't buy as much. That's what we just discussed. When things become more expensive, they buy less. Because all else equal, if you have a certain amount of money, prices just went up, you're not going to be able to get as much. Now, I thought of this as a shift up of the aggregate supply curve.

3:45You could also think about this as a shift to the left of the aggregate supply curve. Say there's some raw material that there's just not as much of. For example, in the 1970s, you had an oil crisis. During the pandemic, during the Covid pandemic, there was a shortage of certain raw materials because there weren't people to work to help transport them or to produce them.

4:10And so you had aggregate supply shift to the left. Some people would call that an external shock or a supply shock. But that could have a similar effect. Price levels would go up assuming that aggregate demand stays the same and aggregate output would go down.

4:26Once again, a cause of inflation. Now, another cause of inflation is if all of a sudden demand goes up a bunch, and actually let me clean up this graph a little bit. I don't know how much I can clean this up. This is letting me clean it up a good bit. So another situation we can imagine is if for whatever reason demand goes up, and actually let's think about that.

4:49Let's think about everyone all of a sudden just having a lot more money in their pockets. And this literally could be some type of the federal government, or actually I should say the central banks maybe print money, put it in people's pockets. So imagine before people had $50 in their pocket or their savings account.

5:07Now, all of a sudden, magically, we won't go into all the mechanics, they have $100. And so in that situation, for any given level of output, more people are demanding it. Or another way to think about it, any given price level, more and more people are going to want more output.

5:24And that is a situation where the price levels would go up, inflation. And we have a situation where aggregate output would also go up. And this goes into a general idea, is that when inflation goes too high, it can be very, very destructive. It can get out of control, it could make people really discouraged about the economy, but a small amount of inflation is actually considered good.

5:47In fact, the Federal Reserve targets about 2% inflation. They consider that a healthy level of inflation that's not getting out of control. It's a sign of a healthy job market, a healthy economy where maybe output is going up by a little bit, hopefully more than the rate of inflation.

6:03But you also have a little bit of inflation going up. You could also have something, like I just described really monetary policy where I'm not getting into the details, the quantity theory of inflation, where if money just becomes easier to borrow, if somehow it gets into people's pockets more, wages could go up.

6:22And also you could have fiscal policy where the government adds to the aggregate demand. And so you could view that as a shift to the right. And you have the same thing happening. The price levels go up and aggregate output goes up. And you could see that sometimes if the government feels like it needs to stimulate the economy.

6:40This also happened during the pandemic. The government said, "Oh, no," because of a supply shock, let's think about it this way, because of a supply shock, you had aggregate supply shift to the left. I don't have to put that arrow there. Aggregate supply had shifted to the left.

7:00And so you were right over there. And so your aggregate output went down. Actually, let me do it from this level right over here. So your aggregate output went down. And so the government did not want the economy to contract. So they add to aggregate demand. So they make the aggregate demand curve shift to the right.

7:25So shift to the right by just maybe borrowing and spending more money than it has. And then you could get back to aggregate output to a reasonable level. And that indeed happened. But both of those moves drove inflation. And you actually saw that coming out of the Covid pandemic.

7:41You saw some of the highest inflation that we've seen in decades. But I'll leave you there. This will give you a generally good idea. Rule of thumb, a little bit of inflation is actually a healthy sign. Too much inflation can be very destructive. And if you actually go into negative inflation, into deflation, that also can get very destructive.

8:02But I won't go into the details in this video.