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Economics 101: 7 key principles you should know

Economics

An understanding of basic economic principles will set you in good stead to understand financial commentary, political rhetoric and make your own assessment of economic risks and opportunities. That is not to suggest you need to become an economic expert but understanding some basic principles will go a long way.  

The foundation of economics… the law of supply and demand

The law of supply and demand is the cornerstone of economic theory.

The law of demand states that as the price of a product or service rises (holding all other factors constant), the level (quantity) of demand for that product or service falls. Basic logic supports this principle because fewer people will be able to afford the product as the price increases and/or an increasing proportion of people will consider it uneconomical to buy it at that (higher) price. The demand curve is downward sloping, as depicted in the diagram below.

The law of supply is the opposite to demand. That is, the higher the price of a product or service, the higher the quantity of the product or service supplied by the economy (i.e., business). Again, this is common sense because as the price of a product or service rises, so does its profitability, so businesses therefore want to produce more.

Supply and demand

The intersection of the supply and demand curves is the equilibrium price. This is the is the price at which the producer can sell all the units they want to produce, and the buyer can buy all the units they want.

A current example

A current example of the law of supply and demand at work is reflected in the price of lettuce – a topic being discussed in the media lately. As we know, supply has contracted due to supply chain issues and floods. Consequently, the supply curve has shifted left, and the price has risen to find a new equilibrium (i.e., equilibrium moves from A to B in the chart below). When supply returns to normal, so will prices.

Example of short supply

Economic output and growth

The economic health of a country is primarily measured using Gross Domestic Product (or GDP). This measures the market value of all the goods and services that a country produces. The formula to calculate GDP is:

GDP = Consumer spending + Government spending + Investment + Net exports

Consumer spending is driven by factors such as employment, age growth and consumer confidence. When consumers are confident, they feel comfortable spending more and GDP rises. Approximately 50% of Australian GDP is generated through consumer spending.

Government spending includes everything that the government spends money on including equipment, infrastructure, public service payroll, etc. Approximately 25% of Australian GDP is generated by government spending, although it’s been higher in recent years due to Covid support measures.

Investment refers to private domestic investment including investments in businesses (e.g., buildings, plant and equipment, etc.), residential property construction and business inventories (stock). Approximately 22% of Australian GDP is generated by investment.

Net exports are calculated by subtracting the value of all imports from the value of all exports. Approximately 3% of Australian GDP is generated by net exports (i.e., approximately $50 billion of exports less approximately $40 billion of imports). High commodity prices have contributed a lot to GDP growth.

Given consumers contribute the most to Australia’s GDP, they are arguably the most important component. Factors such as consumer confidence, wage growth and unemployment are therefore important metrics to monitor.

Historically, Australia’s annual GDP growth rate tends to range between 2% and 4% p.a.

Managing the economy (GDP)

There are two main ways that a government can manage GDP growth being fiscal policy and/or monetary policy.

Fiscal policy refers to factors like government spending (and investment) and taxation. A government can stimulate an economy by cutting/reforming taxes or spending more on things like infrastructure. Most developed economies increased government spending over the past few years to stimulate economic activity to aid the recovery from Covid lockdowns. Major changes to government spending are usually announced in the annual Federal Budget.

Monetary policy refers to the practice of managing money supply. Injecting more money into the economy (i.e., increasing money supply) has a stimulatory effect, and vice versa, because there’s more money to spend or invest. There are two primary ways a central bank (e.g., the RBA) can change money supply. Firstly, it can increase interest rates (the Cash Rate). This means that the cost of borrowing increases and more money is withdrawn from the economy to pay the central bank. Secondly, central banks can issue or buy back (redeem) bonds. This is called quantitative easing which I discuss here.

Employment

Employment is very important because it has a direct impact on consumer confidence and spending. The unemployment rate is talked about a lot in the media. It measures the proportion of people that are willing and able to work at least one hour per week but are not able to find employment. If someone is not looking for work, they are not included in the unemployment calculation.

The participation rate measures the proportion of the working-age population that are either employed or looking for employment. This is also referred to as the labour force. A higher participation rate is a good sign that the economy is healthy.

Wage inflation is also an important measure because the laws of supply and demand tell us that if wages are rising then more people will be attracted to participate in the labour market. Also, higher incomes in turn generate higher levels of consumer spending and therefore increase GDP.  

The exchange rate

A country’s exchange rate is critical for international trade. Firstly, a stable and reliable currency will encourage greater levels of international trade. Secondly, the value of a country’s currency will make either importing or exporting more attractive.

Most currency swaps are benchmarked to, or influenced by, the relative value of the US dollar. When the Australian dollar is high (say above $USD0.75), imports become relatively cheap, but exports become more expensive, which isn’t good for GDP given we export more than we import. A high Aussie dollar is also good for investing because when the Aussie dollar eventually falls to fair value, your investments are worth more.

A low Aussie dollar might be great for exports, but it also makes importing more expensive, which is bad for the Australian economy since Australia does not manufacture a lot of products.

The RBA can manage Australia’s exchange rate through market operations i.e., buying or selling Australian currency to improve its stability (the Australian dollar was floated in 1984). Other determinants of the Aussie dollar include the relative strength of he US dollar, commodity prices, terms of trade (i.e., value of net exports), interest rates and inflation.

Inflation

The law of supply and demand explains that an increasing level of demand will translate to higher prices (assuming supply is unchanged), as the economy finds a new equilibrium. This is inflation. Increasing demand is a positive sign of a growing economy.

However, it is important that the rest of the economy can keep pace with inflation, to ensure its sustainable and there are no negative effects. If wages (income) don’t keep pace with inflation, consumers will be worse off because they won’t be able to afford to maintain their standard of living. It is also problematic if wages and inflation are rising at a fast pace (which is called hyperinflation), as it can cause a lot of negative side-effects such as falling personal wealth, hoarding goods, falling currency and so on.

Low inflation is also bad, as it means that the economy (i.e. demand) is not growing.

Therefore, it’s a fine balance between having some inflation but not too much. It is the RBA job to manage monetary policy to maintain the rate of inflation within the band of 2% to 3% p.a.

Knowledge is empowering

Hopefully this brief introduction to economics helps you understand economic commentary. Not only does this help you better understand the risks and opportunities that might present themselves, but also, I think it’s important knowledge to have so that you can hold our economic managers (i.e., the government) to account.

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