What supply and demand represents has major influence on the cost of goods and services in an economy, how central banks determine what monetary policies to implement and thus affects the valuation of currencies and so much more. Supply and demand is a key term that you must know about if you plan to have some basic understanding of economics.
If you want to learn about what supply and demand is, then continue to read this page. It’s not a difficult concept to understand and I am quite confident that after you have read this page you will have a basic understanding of what supply and demand is. With that said, let’s begin.
What is Supply and Demand
Supply and demand is one the most fundamental concepts in economics. To get a good understanding of what it means, let’s break up the term. First, lets start with supply. Supply is used to address the availability or quantity of goods and services. Demand is used to address the need or want of goods and services while maintaining the ability to purchase or acquire them.
Supply and demand has a major influence on the prices of goods and services. Here’s the formula…
- If supply is greater than demand, then prices will fall over time.
- If supply is equal to demand, then prices will remain stable over time.
- If supply is lower than demand, then prices will raise over time.
The same applies in the inverse…
- If demand is greater than supply, then prices will raise over time.
- If demand is equal to supply, then prices will remain stable over time.
- If demand is lower than supply, then prices will fall over time.
Consider this example. If there is a large supply (large amount) of gold for sale around the world and there isn’t a large demand (large want or need) for that gold, that means that over time gold will decrease in price. Those who sell gold will realize that consumers aren’t purchasing the gold at the current selling price and will be forced to lower prices.
If producers selling gold don’t lower production or in this case excavation, then they will have to continue to sell gold at a lower price. But if those selling gold decrease the rate at which they make gold available to the market, then over time the supply of gold will decrease, which will cause the price of gold to decrease at a slower pace or possibly increase over time. Let’s not forget about the inverse. If consumers start desiring more gold, they will be willing to pay more money for it.
So, as a result, the demand for gold will increase while the supply of gold remains the same. Whenever that happens the price for gold will increase. If producers of gold don’t increase the supply (the rate at which gold is made available), then the price of gold will continue to increase until very few people can afford it. If consumers can no longer afford to purchase gold at elevated prices, then demand for it will decrease.
The effects of supply and demand apply to all goods and services everywhere, not just gold. You can take the example above and replace the word ‘gold’ with any good or service you can imagine and it should still make sense.
Supply and Demand, Central Banks, Their Monetary Polices and Currency Price Valuations
I’ve mentioned above that supply and demand influences central banks, the monetary polices they implement and thus influences currency price valuations. You may not understand what I meant when I said that, so let me explain in more detail. Do you remember when I said that supply and demand applies to every good and service in an economy? Well, it even applies to currencies. Because supply and demand applies to currencies, it can also affect a currency’s valuation just as supply and demand can affect the prices of goods and services. And because supply and demand can affect a currency’s valuation, it also can affect a central bank’s decision on the monetary polices it plans to enacted.
Consider this example. If citizens in a country are struggling to find jobs, they would naturally spend less money because they aren’t earning money. If consumers (who are the citizens) aren’t spending money, then producers (companies) aren’t earning money either (or not as much money) because jobless consumers (or citizens) aren’t spending money. There is a great need for money (currency) because consumers (citizens) don’t have it and producers (companies) aren’t earning enough. With less people buying things, demand for goods and services will also decrease, which would lead to a drop in prices, known as disinflation which could lead to deflation if severe enough.
Do you see the supply and demand in this scenario? Demand for currency has gone up while supply of currency has remained stagnate. Because demand for currency is going up, while the supply of currency has remained unchanged, that means the valuation of the currency will increase and thus the prices of goods and services will decrease. I hope you’re following along.
Here’s where the central bank comes in. The central bank would enact expansionary monetary polices in an effort to infuse the economy with more currency and thus increase the money supply. The results of a central bank increasing the money supply of an economy would be that citizens would then end up with additional money. With additional money in their possession, they will hopefully spend more. As a result, producers (companies) will earn more money and thus hire more people to help with the increase in business.
Now that more people have jobs because of the recent hiring, those people will increase their spending also because they have more money to spend. And the cycle continues. More spending, more jobs, more jobs, more spending. Eventually it will get to a point where there is a lot of spending going on because many people have lots of money to spend. Think about supply and demand in this scenario. Now that many people have lots of money to spend, the supply of money may become greater than the demand. When supply is greater than demand, prices fall, and in this case, currency price valuation falls and thus prices for goods and services increase; this is known as inflation (if it gets really bad, it is known as hyperinflation).
To combat the high supply of money, a central bank would have to enact contractionary monetary polices, which would decrease the amount of money circulating in an economy. Its a constant balancing act.