Economics 101

Smashed avo on toast and a double shot, turmeric latte with macadamia-nut milk costs less today than smashed avo on toast and a double shot, turmeric latte with macadamia-nut milk tomorrow. Congratulations. You now know what inflation is. Those important people on tv in overpriced suits tend to complicate things but that’s literally all it is. Inflation is just a word economists use to describe a natural (for the most part) increase in the prices of goods and services over time.

Obviously, calculating inflation is much more difficult. In Australia, we use something called the consumer price index. Our central bank (the Reserve Bank of Australia or RBA) takes a customary ‘basket of goods’ divided into 11 major groups (e.g. housing, education, health, birkenstocks (clothing – if you could call it that), avocado (food)), and keeps track of how that basket of goods changes in price over time. Inflation is a concept everyone should be familiar with because it’s something which will certainly impact your life. Below are some more fancy terms those important suit people tend to use.

Demand and supply

According to a probably unreliable website, despite my protestations, 25 million pairs of birkenstocks were sold globally in 2017. There was demand in the global market by misguided fashionistas for 25 million pairs of these sandals. Similarly, there was (at least) 25 million pairs worth of supply in the market.

High demand for any good or service drives up its price (and vice versa). High supply of any good or service pushes down its price (and vice versa). Where demand and supply meet, we get ‘equilibrium’ – or the fair market value for the good or service. I’ve drawn up a standard demand & supply curve (not all that curved tbh) below to help us visualise shifts in demand and supply.

  • If the materials which go into producing birkenstocks ever became a scarce resource (a man can hope), consumers can expect to see an increase in price, as the decreased supply shifts equilibrium to the left.
  • If better technology allows Birkenstock to produce more efficiently and Birkenstock overproduces, consumers can expect a downward shift in price, as the increased supply shifts equilibrium to the right.

The logic on the demand side is very similar. 

  • If summer comes early and We The People collectively demand more pairs of these comfy sandals, consumers can expect to see an increase in price, as the increased demand shifts equilibrium to the right.
  • On the other hand, if We The People come to our senses and start buying literally anything else, please, consumers can expect to see a decrease in price, as the decreased demand shifts equilibrium to the left.

Obviously fluctuations in price are far more complicated than that. Everything from inflation to exchange rates to boring marketing people are factors which play a role in determining how much Birkenstock will charge for their pair of iconic sandals.

Opportunity cost

If you’ve recently started a law degree at a Go8 university (wannabe Australian ivy league equivalent), you might be in the market for an overpriced pair of boots. So, with ~$600 in hand you scurry off to your closest R.M. Williams retailer and exchange your hard-earned dollarydoos for a comfort craftsman boot strapped with more leather than there was on the cheesy jacket John Travolta rocked on Grease. Your cost is $600. Your opportunity cost is what you give up to finance your love affair with your craftsman boot. It’s the value of the most valuable alternative to the decision you settled on. Opportunity cost is a concept used by investors to make smarter investment decisions. Opportunity costs almost always go unnoticed because they’re out of sight, out of mind but carefully considering your alternatives helps you weigh up potential returns and risk profiles. You can also apply this logic to everyday purchase decisions. For example, the opportunity cost of your craftsman boot might be:

  • a new phone (or 1/3 of a new iPhone);
  • tickets to like 9 different gigs;
  • 20 brunch dates; or
  • 170 cups of coffee.

GDP

GDP stands for gross domestic product. It’s a single figure representing the sum of all final goods and services produced in a country within a fixed time period (usually a year or quarter). In my opinion, that shouldn’t be enough to satisfy your curiosity though so here’s exactly what it’s made up of. There’s a fancy formula for calculating GDP and it goes like this:
C + G + I + NX = GDP

In this formula, C stands for consumer spending (e.g. on birkenstocks), G stands for government spending (hopefully not on birkenstocks), I stands for gross investment (if you’re at a point where you’re investing in birkenstocks, you need a new hobby) and NX stands for net exports which is the difference between how much a country sells overseas and how much that country buys from overseas.

GDP growth is a metric economists (and unfortunately politicians) use to determine how quickly the economy is growing. In a capitalist economy, markets are competitive and economic growth is necessary. If the economy isn’t growing and the population is, this becomes troublesome because we simply wouldn’t have enough jobs for everyone.

Recession

We mentioned above that GDP growth is often measured annually or quarterly. If GDP falls in two successive quarters, you have recession. This is not a great place to be. Politicians start scrambling and over-spending to try to kick-start the economy, and central banks start to conduct expansionary monetary policy (see below) to encourage investment. One thing to note if you’re an investor is that during a recession, essential goods and services (e.g. food, housing, healthcare) tend to be less impacted than discretionary goods and services (e.g. R.M. Williams boots, birkenstock sandals, holidays).

Monetary policy

A brilliant friend and colleague once told me that most central banks (such as the RBA or the Federal Reserve in the US) only really have a single lever they use to influence the economy. He was referring to the cash rate. The cash rate is a tool central bankers use to encourage or discourage borrowing, investment and expenditure. When the economy is performing well, central banks increase the cash rate (contractionary monetary policy). No central banker wants to be responsible for creating asset bubbles because they’ve kept the cash rate at ridiculously attractive levels for an extended period of time (except Australian central bankers apparently). When the economy is under-performing, central banks decrease the cash rate to stimulate investment and growth (expansionary monetary policy). 

Unemployment rate

Contrary to unpopular political opinion, the unemployment rate is not a measure of the proportion of lazy, dole-recipient millenials splurging on cauliflower lattes at cafés run by hipsters with perfectly-manicured, Game of Thrones inspired beards, in a population. The unemployment rate is the ratio of a country’s unemployed population to its labour force. The unemployed population includes people who are not doing paid work but are actively looking for paid work (by definition, those darned, lazy millenials are excluded). The labour force includes a country’s employed and unemployed populations. It does not include those who are not looking for work, such as retirees and those who are permanently unable to work. Something important to understand about the unemployment rate is that it influences monetary policy. If unemployment rises too high, central bankers will factor this into a decision in favour of decreasing the cash rate (see above).

Why should you care?

Well, because economics is super cool. I know, tough pitch. But I had that level 85 paladin back in high school so I know a thing or two about cool. Economics can help you time when you want to make big investment decisions in your life. For example, buying an investment property when the cash rate is low naturally means your mortgage repayments are lower because your lender’s rates are lower. Buying the same investment property after two consecutive periods of negative GDP growth (which means? … correct! recession! ugh I’m so proud of y’all, this is what parenthood must feel like) is dangerous. If the economy is in recession territory, jobs are more at risk than they would otherwise be, and people are more likely to default on their mortgage repayments (which consequently might put downward pressure on house prices).

There’s so much more to the exciting world of economics to geek out over (and we definitely will) but the above are some fundamental concepts I think everyone has a right to know.