A sound knowledge of economics is important, as it affects the choices that all of us make on a daily basis. There are three key concepts that you should be familiar with: scarcity, supply and demand.
Scarcity
Scarcity means there are limited resources to meet unlimited requirements. This means we have to make decisions about how to allocate limited resources efficiently. This is the basic role of an economy.
Demand and supply
Markets – including the property market – are driven by demand and supply.
The law of demand means that as prices increase, demand decreases, and as prices decrease, demand increases.
Similarly, the law of supply means that as prices increase, supply increases, and as prices decreases, supply decreases.
In the property market, for example, where demand for housing is high but supply is low, house prices will increase. This can lead to competitive bidding, which further drives prices higher.
These concepts can be seen visually on the chart (below). Equilibrium price is where demand matches supply, being the intersection of the lines on the graph.
Many factors affect both demand and supply. In the property market, demand is driven by demographics (marriages, divorces and deaths), preferences (buying versus renting), interest rates, mortgage availability and income. Supply is driven by factors such as cost of construction, labour and land, government policy (taxation and incentives), new construction technology (modern methods of construction) and public spending on social housing.
Price elasticity also comes into play, being the degree to which price changes affect demand and supply. In the property market, supply is generally price-inelastic as building new housing is a slow process. This means changes in demand will have a more significant effect on prices.
Economic indicators
Once we understand how markets operate, we need to look more widely at the indicators of good economic health.
These include:
- Gross domestic product A measure of all goods and services produced over a period of time. An economy is growing when GDP increases.
- Inflation This is the rate at which prices are increasing. In the UK, the Bank of England has a target of 2% for inflation. The Office for National Statistics publishes a monthly Consumer Price Index (including housing, CPIH) figure, which relates to the prices of more than 700 items that are regularly purchased – for example, a loaf of bread, bus ticket, a car, housing and a holiday.
- Unemployment
- Inequality This relates to the distribution of wealth, which to be healthy should be as equal as possible.
High inflation
CPIH is running at 8.8%, which is substantially over the Bank of England target. This ONS chart below shows the trend of CPIH over time.
Recent high inflation is primarily due to increased energy and food prices. This has been a result of the Russian invasion of Ukraine and pressure on businesses to charge more for their goods and services. The government has announced a price cap on energy bills to help curb their impact on inflation. The cap will end in April 2023.
As low inflation is an indicator of a healthy economy, we can take from this that high inflation is likely to be problematic. Unstable prices create uncertainty for the purchasers, as purchase decisions cannot be planned effectively. In extreme cases, economies can collapse, which happened in Zimbabwe in 2007-2009.
In the UK, the Bank of England believes inflation should start to fall from around 10% in early 2023, but it will take time for it to be reduced back to target levels.
Interest rates
The Bank of England sets monetary policy to try to keep the rate of inflation stable and close to its target. The primary mechanism for doing so is by setting the bank rate (often referred to as the base rate). This is the rate at which the Bank of England lends money to commercial banks. This then affects interest rates that high street banks offer to consumers, for example, in mortgages. Consumer interest rates are also affected by the specific risk of the lending decision and the loan term.
Interest rates are linked to inflation because when interest rates are high, it is expensive to borrow money and people tend to save. This means consumer spending declines, causing prices to rise more slowly (inflation decreases).
When interest rates are low, it is cheap to borrow money and the returns from saving are minimal. This encourages consumer spending and increases prices, thus also increasing inflation.
Interest rates were increased by the Bank of England from 0.1% in December 2021 to 2.25% in an attempt to reduce inflation to target level.
Interest rates were reduced (and have stayed low) from 5% to 0.5% as a result of the 2008 financial crisis. This has helped support consumer spending and levels of employment.
This will have a substantial impact on borrowers with existing variable-rate mortgages or those looking to take out new borrowing. Existing fixed-rate mortgages will not be affected until they expire. However, savers with cash in the bank will see additional income through interest generated on capital.
The Bank of England has not confirmed how much it will increase the bank rate by, which creates uncertainty for borrowers for the medium term future.
Quantitative easing
Another mechanism is quantitative easing, or QE, where the Bank of England buys government (also known as gilts) or corporate bonds.
This increases the price of the bonds, causing the bond yield (or interest rate) to decrease. This decreases interest rates for consumer and business lending, boosts borrowing and consumer spending, and so reduces inflation.
The government’s latest Autumn Budget led to increased government bond yields and reduced prices, in addition to a reduction in the value of sterling against the dollar. This was because of the perceived amount of government borrowing required to fund the tax cuts announced in the budget.
This led to the Bank of England announcing a £65bn QE programme to stabilise the gilts market and reduce the impact on UK pension funds. This lending to the government (through buying bonds, or QE), should bring down interest rates on government debt and have a knock on effect on wider interest rates.
The quick quiz
1. What does RPI stand for?
- a) Retail Price Index
- b) Regular Price Index
- c) Real Estate Price Index
2. What does RPI include that CPI does not?
- a) New cars
- b) Mortgage interest payments
- c) Saving interest rates
3. What is the current GBP to USD exchange rate?
- a) 0.8
- b) 1.15
- c) 2.2
Answers: 1: a 2: b 3: b
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Further reading and resources
Jen Lemen BSc (Hons) FRICS is a co-founder and partner of Property Elite
