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7 key principles you should know

An understanding of basic economic principles will set you in good stead to understand financial commentary, and 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 of 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.

Price Of Lettuce 1

The intersection of the supply and demand curves is the equilibrium price.

This 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.

Supply And Demand 1

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 the 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, plants, equipment, etc.), residential property construction, and business inventories (stock).

Approximately 22% of the Australian GDP is generated by an 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 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 the 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 the money supply.


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