What is economics?

Simply put, economics looks at people, resources and the choices people make when trying to optimise and conserve these resources.

Ultimately, economics affects everyone. On one level, economics helps us to understand the hows and whys of our purchasing choices. On a broader level, learning about economics provides important insights into how markets operate, how governments plan policies and how economic forces power social systems.

The state of the world’s economy plays one of the biggest roles in the price of most assets. Because crypto is, for the most part, decentralised with participants in most countries, it’s affected by the macroeconomic events of almost every country. 

Micro and macroeconomics

Economics can be broken down into two general categories: microeconomics and macroeconomics. 

Microeconomics looks at the decisions of individuals and businesses and how these decisions affect the price of an asset (e.g. comparing how many investors have purchased an asset over the last month to how many have sold the same asset).

Macroeconomics takes a wider lens approach by examining the decisions made by a country or government that may affect the price of an asset (e.g. a country’s crypto regulations). 

Microeconomics and macroeconomics are often used together to guide investment decisions. Both enable researchers to make price predictions and understand the current market. The main difference is that microeconomics takes a bottom-up approach, whereas macroeconomics takes a top-down approach. 

Supply & demand 

In simple terms, the laws of supply and demand help to explain the relationship between the price of a resource (i.e. good, service or product) and people’s willingness to buy or sell it. 

The law of demand states that, the higher the price of a resource, the lower the level of demand and vice versa (provided that all other factors remain constant).

This law considers the relationship between price and demand from the perspective of the buyer. Because buyers have finite resources (e.g. money), their ability to spend on a certain resource is limited as well, meaning that higher prices will result in a decrease in the quantity demanded. On the other hand, demand will rise as the resource becomes less expensive. 

The law of supply holds that the higher the price of a resource, the higher the supply and vice versa (again, with all other factors being held constant). This law considers supply and price from the perspective of the supplier. Higher prices will incentivise sellers to supply more of a particular product/resource, provided that their costs aren’t also increasing. Conversely, lower prices will reduce the supplier’s profit margin, resulting in a curb in supply.

Logically speaking, consumers will seek out the lowest costs, whereas suppliers will try to sell their products as much as possible. This results in the need for some kind of balance to be achieved whereby both parties are happy. When this ‘balance’ is reached, it is known as the ‘equilibrium price,’ i.e. the price at which demand matches supply and is acceptable to both buyers and sellers.

The laws of supply and demand are fundamental for investors, entrepreneurs, economists or anyone who is trying to understand and, in some cases, predict market conditions. However, it’s very important to note that these laws explain how supply and demand work from a theoretical standpoint. In reality, multiple other factors can cause supply and demand levels to fluctuate, including consumer income, preferences, taxes and regulations. 

Another important point is that supply and demand do not always respond to price movements proportionally. The extent to which changes in price will affect a resource’s supply or demand is referred to as its price elasticity. For example, a product with a high price elasticity of demand will experience greater fluctuations in demand following a change in price. On the other hand, basic necessities such as electricity are relatively inelastic in price, as people can’t easily live without them. 

What is inflation? 

In basic terms, inflation is the rate at which goods and services go up in price. If the supply of money is increasing, then the value of the currency (i.e. purchasing power) is decreasing. 

There are two basic causes of inflation: 

1. A sudden increase in the supply of actual currency in circulation. 
2. A shortage of specific goods or services that are in demand. This can cause a general rise in prices for those goods or services.

There are two main technical terms to describe these types of inflation:

1. Demand-pull is the most common type of inflation caused by increased spending. In this case, demand outweighs the supply, causing prices to rise.
2. Cost-push occurs when prices rise due to an increase in production or material costs, shortages in resources or increases in taxation on goods. Those costs are “pushed” to the consumer.

There is also the concept of “built-in inflation”. Built-in inflation relates to the idea that people anticipate inflation rates to continue to rise in the future. For example, because of this expectation, employees may demand an increase in wages to keep up their standard of living. An increase in wages may result in an increase in the cost of goods and services; this in turn may result in a wage-price spiral where one factor continues to fuel the other.

Governments and central banks attempt to limit the impact of inflation by altering the money supply and changing fiscal and monetary policy. Central banks can alter the supply of fiat money by increasing or decreasing the amount in circulation. In practice, central banks typically raise interest rates to control inflation. This makes it more expensive to borrow money, and credit becomes less attractive to individuals and businesses, causing the demand for goods and services to fall. 

Fiscal policy refers to governments’ control of taxes to influence the economy. If a government increases the amount of income tax they collect, individuals will have less disposable income, reducing market demand. 

In many countries, the Consumer Price Index (CPI) is used to measure inflation.

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Consumer Price Index

The Consumer Price Index (CPI) is a measure of the monthly, quarterly, or yearly change in prices paid by consumers in a specific country/region.

Because CPI indicates price trends, it is a key marker for inflation/deflation. CPI is widely used by central banks (e.g. the U.S. Federal Reserve) to guide monetary policies. 

CPI is calculated using weighted averages of prices for a representative basket of goods and services.

The “basket of goods and services” is made of a sample of goods and services which includes several different categories such as food and beverages, housing, transportation and education. The items that make up the sample are chosen based on information regarding consumer spending habits. 

The prices of each item within the basket are based on approximately 94,000 price quotes collected from retail, service and rental housing units. The averages of these prices are then weighted to account for the goods/service’s varying degrees of importance (also determined using consumer spending data).

Note: there’s more than one way to calculate CPI; below is an example.

CPI Formula:

((C - P) / P) x 100

C = current price of a representative basket

P = the base period’s price.

So, for example, let’s say that the basket cost was $2,000 in 2021 (base year), and in 2022, the cost of the basket rose to $2,050. 

Therefore:

((2,050 – 2,000) / 2,000) x 100 = 2.5

This means that for the period beginning in 2021 and ending in 2022, the CPI was 2.5, i.e. inflation was at 2.5% (prices rose by 2.5%).

Gross Domestic Product 

Gross Domestic Product (GDP) represents the total market value of all finished goods and services produced within a region’s borders in a specified time period. The term “finished goods” refers to those that have gone through all stages of production and are being held for sale.

Because GDP gives a broad overview of domestic production, it’s seen as a marker of a region’s overall economic health and growth rate.

There are three main types of GDP:

Nominal GDP: values goods and services at their current market price, meaning that it does not adjust for inflation/the pace of rising prices. 

Real GDP: measures the number of goods and services produced while controlling for price inflation. This allows economists to get a better idea of whether changes in GDP are a result of economic expansion/contraction or just changes in price. 

GDP per capita: a measurement of how much economic production output can be attributed to each individual citizen. 

The Expenditure Approach is the primary method used to calculate the GDP in the US; the formula is:

C + G + I + NX = GDP

C = Consumption (all consumer spending)

G = Government spending (e.g. payroll, infrastructure and equipment)

I = Investment (all private domestic investment and capital expenditures)

NX = Net exports (all expenditures by companies located in a given country, even if they are foreign companies, are included)

Note: Real GDP is calculated using a “price deflator”, which takes into account the difference in prices between the base year and the current year. For example, if prices rose by 7% since the base year, the deflator value would be 1.07. Real GDP is then calculated by dividing the nominal GDP by the deflator. 

GDP Growth Rate is a comparison of the year-on-year (or quarterly) change in a region’s economic output. Growth rate compares real GDP and is typically expressed as a percentage and is viewed as an indicator of how fast an economy is expanding or contracting. 

A basic understanding of economics can be a powerful tool for crypto investors. It helps investors see how different factors affect the crypto market and guides them in making informed investment decisions.