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Much thinking about inflation is rooted in the concept of the market elaborated by Adam Smith in the mid-i8th century. The mechanisms that rule the market, as Smith described it, are supply and demand, and prices hinge on the relation between the two. When the demand—that is, desire backed up by buying power—for a certain kind of merchandise exceeds the supply, its cost rises. This, however, is not the misfortune it might seem to be, at least according to Smith and his followers. Because the item brings more income to its producers, more people attempt to produce it. This in turn increases supply until it outstrips demand. Producers must now compete by lowering their prices. If 20 million fami¬lies lived in a country with only 10 million refrigerators and each family attempted to outbid the others for them, the price of a refrigerator might be very high. But if, in consequence of the high price, more workmen and money were to be drawn into the refrigerator business and an additional 20 million units were to be manufactured, a “buyer’s market” would eventually result, causing the price of re¬frigerators to plunge.
Other economists, however, deny that supply and demand really do have the effect that Smith attributed to them. This is not necessarily a moral criticism of the selfishness that animates the market; they simply assert that the ruling powers of private enterprise economies have in fact liberated themselves from the restraints of supply and demand.
Much thinking about inflation is rooted in the concept of the market elaborated by Adam Smith in the mid-i8th century. The mechanisms that rule the market, as Smith described it, are supply and demand, and prices hinge on the relation between the two. When the demand—that is, desire backed up by buying power—for a certain kind of merchandise exceeds the supply, its cost rises. This, however, is not the misfortune it might seem to be, at least according to Smith and his followers. Because the item brings more income to its producers, more people attempt to produce it. This in turn increases supply until it outstrips demand. Producers must now compete by lowering their prices. If 20 million fami¬lies lived in a country with only 10 million refrigerators and each family attempted to outbid the others for them, the price of a refrigerator might be very high. But if, in consequence of the high price, more workmen and money were to be drawn into the refrigerator business and an additional 20 million units were to be manufactured, a “buyer’s market” would eventually result, causing the price of re¬frigerators to plunge.
Other economists, however, deny that supply and demand really do have the effect that Smith attributed to them. This is not necessarily a moral criticism of the selfishness that animates the market; they simply assert that the ruling powers of private enterprise economies have in fact liberated themselves from the restraints of supply and demand.
In any case, whatever the relation between supply, de¬mand, and prices, it must be understood that the “supply” of an economy as a whole is its total output—meaning the volume of goods and services produced by the entire economy. Changes in this output from one period to another must be measured by means that enable us to distinguish between real growth in the volume of goods and services produced and apparent growth due simply to inflation. We can do this by differentiating the “real income” due to pro¬duction from the “nominal” or “money income.” Nominal income is obvious enough: It is the value of an economy’s total production at the prices it actually does fetch when sold. If, however, the general price level changes, the pur¬chasing power of the money embodied in nominal income will also change. Consequently, a rise (or fall) in nominal income does not indicate how much of any increase (or decrease) occurring from year to year was due to increased (or decreased) production of goods and services
and how much to inflation (or to its opposite, deflation). We can find out, however, by recalculating the income from two or more years that we wish to compare to make the pur¬chasing power of money equal in all of them.
Suppose, for example, that in one year an imaginary economy generated a nominal income of $20 billion. Five years later its nominal income had risen to $25 billion. It will be most simple if we use the dollar’s value in the first year as the base for our calculations. (In principle, how¬ever, any other year would serve just as well.) In this year, in other words, $1 = $1, and both the economy’s nominal and its real income amounted to $20 billion. When its nominal income had risen to $25 billion, however, its cur¬rency had lost, say, 20 percent of its value as a result of a corresponding rise in the general level of prices, so that % 1 = $0.80. The economy’s real income in the latter year was therefore only $20 billion. Inflation generated the whole of the increase in its nominal income; the pro¬duction of goods and services did not rise at all.
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