Supply and Demand Theory 101

I loved economics at University.  I found that it was interesting and (mostly) logical and it explained things that happened in the financial marketplace in a way that made sense. 

One of the things that we learned was the theory of supply and demand.   This theory states that, in a free market with no trading constraints, the price of goods is set by the interaction between the buyer (the demander) and the seller (the supplier).

At the point where the demand and the supply curves meet is where the equilibrium price of goods is set.    

Fast forward to 2022. 

We have very high inflation in NZ.  We import a lot of our goods from overseas, and with all of the money that was put into the NZ economy in 2020 and 2021 as part of the covid response, the money supply is high. 

There are supply chain issues globally, which means that it is harder to get goods to NZ and the time delays mean that people are waiting longer for things that they order.    The supply curve then moves to the left, which results in the cross over of price being at a higher point on the curve if the demand stays the same.  However, there is more money in the economy and people potentially are spending more on things like white ware and home improvements.  There is more demand for some things, so the demand curve is also moving to the right and this gives us an even higher equilibrium point, which is the new price.  

Inflation is paying more for goods.    This is a function of not enough supply to meet the demand because the supply is less or the demand is more – or both. 

This has been a key driver with house prices in New Zealand over the last decade – we have had a massive undersupply of housing leading to meet the demand, therefore the price equilibrium gets higher.    When we have had a housing price decrease, it is because there are more houses for sale (supply) than people want to buy (demand) and the price drops away until a new market equilibrium price point is achieved.   This is where the markets were at in Auckland in 1991 when we bought our first house.    

Interest rates are increasing , which makes it more expensive to service debt.  This means that borrowers are allocating more money to debt and therefore have less money to spend on other things.  This should mean that, over time, there will be less demand for some “luxury” goods.  A lower demand means that the price should fall if the supply remains the same. 

This is potentially where the housing market may go over the next few years.  HOWEVER, if people choose to leave NZ to work overseas and sell their homes, we may see an increase in the supply at the same time.  The size of the fall in demand vs the potential increase in supply will be the key factor in determining where the equilibrium settles.   

What we are seeing in the local economy at present is the logical outworking of some movement in key economic drivers.   It is not an out of control phenomena that we should all be panicking about.  The current situation is the logical outcome of earlier occurrences.   

The effects of the drivers that we are seeing in the current market will flow through and should taper off at some point, so what we are experiencing should not be a permanent change. 

Janet Natta is a financial adviser and director of Smart Money Advice, offering investment portfolio construction and management services to clients throughout NZ, as well as comprehensive financial planning advice to assist clients to build and protect wealth to achieve their dreams.

DISCLAIMER: The information contained in this article represents the views of the author. It is based on information believed but not warranted to be correct.   Any views or information, whilst given in good faith, are given with an express disclaimer of responsibility and no right shall rise against any of the authors or Smart Money Advice or their employees either directly or indirectly out of any views, advice or information.