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Demand and supply are fundamental blocks to understanding how markets function. A market is a place where buyers and sellers meet. However, the interaction between buyers and sellers is driven by two important forces, namely, demand and supply. Demand measures the amount of a good or service a buyer is able and willing to buy at a given price. Supply measures the ability and willingness to produce at a given price. The demand for a good or service is a function of various parameters such as taste and preferences, income level, availability, or other similar goods. Similarly, the supply of a good or service is a function of various parameters such as the cost of input, the technology used in the production, and the market size of the product. This blog elaborates on a few crucial concepts that will help you understand demand and supply better. Two of them are price and equilibrium. The common link between demand and supply is price. In economics, the word equilibrium is used when market demand is met by market supply. The result leads to price and quantity determination. In other words, an equilibrium is met when demand and supply forces meet such that the good that is produced by the seller is bought by the buyer at a mutually agreeable price. There can be two cases under which market equilibrium is not met. Excess supply: Under this condition, the market supply exceeds market demand. Imagine the case where charging infrastructure is developed by the government across the city. However, the demand for electric vehicles, and hence the demand for charging is low. Under this scenario, the market for charging infrastructure experiences an excess supply. Excess demand: Under this condition, the market demand exceeds the market supply. Imagine the case where the demand for electric vehicles is high as consumers have become sustainable in consumption. However, firms are not able to match the demand and there is a shortage in production. In this case, the market for electric vehicles experiences an excess demand. When prices can’t adjust to this, they either increase or decrease. In the case of excess demand, the market price is higher than the equilibrium price, and the good or service becomes costlier. Under a case of excess supply, the market price is lower than the equilibrium price, and the good or service becomes very affordable.  In many cases, government intervenes through policies to regulate prices. These are called price control mechanisms. Price Ceiling: Under a price ceiling, the government places a cap on the maximum price that can be charged by the producer. In such a case, the producer cannot charge the buyer a price above this price ceiling imposed by the government. Take for example the case of Uber. Under situations of high demand, the fare of cabs increases, and Uber practices a principle of ‘surge pricing’, which is to price cabs more during times of peak demand. Now, imagine if the government were to restrict surge pricing by placing an upper cap on the price that Uber can charge, even during peak demand. This would be a good example of a price ceiling. A price ceiling is usually effective if placed below the equilibrium price. A price ceiling above the equilibrium price is ineffective, as the market clears at the equilibrium price. Price Floor: Under a price floor, the government supports the firm/industry through price support. A price floor essentially means a minimum support price, below which the price shall never fall. It is a kind of government-mandated support to the producers of the good or service such that the producers do not face a loss under uncertain demand or an economic downturn. A good application of the price floor is government support in the form of subsidies to agricultural farmers and dairy farmers. The government often provides a monetary subsidy to the farmers and buys the extra surplus that is generated at the level of the price floor. A price floor is effective if it is placed above the equilibrium price. When the equilibrium price level is perceived to be low, the government provides a price floor that is above the equilibrium price. A price floor below the equilibrium price will be ineffective, as the market equilibrium price will be above the price floor at which the market will in any case be in equilibrium. Understanding demand and supply is crucial to design policies. While at the surface, it seems to be easy, understanding which phenomenon is a demand-side one versus a supply-side one is sometimes confusing and tricky. Take for example the case of food inflation. Food inflation refers to the increase in prices for food commodities in an economy. However, food inflation can be either a supply or demand side phenomenon. Food inflation can be due to a drought or due to the vagaries of climate change. This causes the supply of food to decline, causing a supply shortage, which eventually leads to a price increase. On the other hand, food inflation can also occur due to an increased demand for certain food items in the market. The role of the Central Bank, as well as the government, is to first understand the cause of inflation, and then frame policies that will best be suited for the situation. For example, if the problem is a supply-side phenomenon, the government should find ways to increase the supply by providing subsidy support to the affected farmers. Similarly, if inflation is a demand-side phenomenon, then framing appropriate demand-side policies will correct the situation rather than looking at supply-side solutions. Framing policies that are different from the reason for the phenomenon could adversely affect the phenomenon at play. For those looking to get an in-depth understanding of such topics, Principles of Economics Essentials You Always Wanted To Know is an easy-to-understand guide on all the essential economics concepts, including demand and supply.  This book is a part of Vibrant Publishers’ Self-Learning Management Series and is suitable for both students and experienced professionals. This blog is written by Cledwyn Fernandes, author of Principles of Economics Essentials You Always Wanted To Know. Book Cover of Principles of Economics Essentials You Always Wanted To Know Find out more about the book here: Link to the book: Principles of Economics Essentials You Always Wanted To KnowAuthor: Cledwyn Fernandes Press Release: A Complete Guide To The  World Of Economics Also Read: How Does Economics Explain Inflation?What is a Market in Economics?Microeconomics is Essential For You!

Policy-making is an art. Designing effective policies that can address the situation at hand is a sign of an efficient policymaker. The two key entities that are responsible for policymaking in an economy are (a) The Government (for fiscal policies), and(b) The Central Bank (for monetary policies). The role of the government is to promote sustainable growth, reduce inequalities, and improve social welfare in the economy. The role of the Central Bank is to ensure that inflation is stable in the economy. However, both these policies are like two taps that release water into the economy. It is therefore extremely crucial to balance the taps as an uneven flow from one could have an adverse effect on the economy. Let’s now understand fiscal and monetary policies in detail. Fiscal policy refers to the actions taken by the government to maintain employment and output stability. Through its revenues and expenditures, the government frames policies to enhance economic growth. The fiscal policy can be expansionary or contractionary in nature. An expansionary fiscal policy is one where the government reduces taxes or increases subsidies and welfare schemes and expenditures towards infrastructure projects with the aim of increasing economic growth. For example, building a highway, investing in clean energy projects, or providing subsidies to farmers are all examples of an expansionary fiscal policy. On the other hand, a contractionary fiscal policy is one where the government increases taxes or reduces expenditures and subsidies to bring down economic growth. This phenomenon is seen during times of high boom, which could lead to high volatility in the market. This is termed a contractionary monetary policy. Monetary policy refers to the actions taken by central banks to pursue objectives such as price stability, and economic growth. In the United States, the Federal Reserve (popularly known as The Fed) is the central bank of the economy. Just like the fiscal policy, the monetary policy can be expansionary or contractionary. An expansionary monetary policy is when the central bank pursues policies to increase the money supply in an economy. The central bank does this by either reducing policy rates (which in turn reduces lending rates by commercial banks) or reducing the reserve ratios (the amount of money that retail commercial banks need to keep with the central bank). There are a few other ways by which the central bank can affect the money supply in the economy. However, the central point of an expansionary monetary policy is to increase the amount of money in the hands of the people to induce spending, which in turn leads to higher economic growth. On the other hand, a contractionary monetary policy is one where the central bank pursues policies to reduce the money supply in the economy. The central bank does this by increasing policy rates (which in turn increases lending rates by commercial banks) or increasing the reserve ratios (the amount of money that retail commercial banks need to keep with the central bank). A contractionary monetary policy reduces the money supply in the economy which in turn reduces spending and lowers economic growth. A contractionary monetary policy is most effective during times of high inflation. The goal of the policy is to reduce inflation and maintain price stability. Fiscal and monetary policies are two taps of the same pipe. It is therefore important that there is close coordination between the central bank of an economy and the government. For instance, if the government is reducing taxes, and investing in infrastructure projects that would lead to higher economic growth in the economy, the central bank should complement this policy by reducing interest rates and reducing the reserve ratios which would yield higher economic growth and boost the fiscal policy by the government. In case the monetary policy takes a reverse stance as compared to the fiscal policy, it would result in conflicting results. Designing effective policies first requires policymakers to understand the current state of the economy. Careful diagnosis of the problems and issues will lead to correct and effective policies that can provide a remedy. The effectiveness of a fiscal and monetary policy depends on a large variety of factors such as time lag between implementation and outcome, the cause of the problem, and the impact that the policies can have on the economy. Consider the case of the Great Recession in 2008. The initial response under both Bush and Obama’s administrations was a fiscal stimulus – which was to increase the income of the economy through large-scale transfers. The Bush administration facilitated tax cuts, while the Obama administration facilitated increased spending. The Fed complemented the fiscal policy by reducing interest rates. However, as the recession deepened, the governments pulled back on spending with the fear that the economy would enter into high debt in the future. Thus, this was a clear scenario of The Fed and the U.S. Congress being at odds with each other. Governments are usually concerned about the economy’s debt and deficit level which can have political consequences in the future. The Fed is concerned about inflation and price levels. Therefore, there could be times when both policies are moving in opposite directions. Book cover of Principles of Economics Essentials You Always Wanted To Know - a handy guidebook to the world of economics. This blog is written by Cledwyn Fernandes, author of Principles of Economics Essentials You Always Wanted To Know.  In the book, Cledwyn has dedicated a chapter to fiscal and monetary policies, wherein he goes into the details of how these policies impact the economy and the application of fiscal and monetary policies in different economic scenarios. The book is an easy-to-understand guide on all the essential economics concepts related to the world of economics and is a part of Vibrant Publishers’ Self-Learning Management Series. Find out more about the book here: Link to the book: Principles of Economics Essentials You Always Wanted To KnowAuthor: Cledwyn Fernandes Press Release: A Complete Guide To The  World Of Economics Also Read: Demand, Supply, Price, and Equilibrium - The Fundamentals of EconomicsHow Does Economics Explain Inflation?What is a Market in Economics?