Thursday, January 29, 2009

Detoxing the Economic Crisis2: Understanding basics

It is important for Raperas to understand some basic facts about how the economy works. In a free market (which ours is to a large extent), two important forces that move the economy is "demand" and "supply". These are collectively called market forces and the interplay between demand and supply not only affect prices and costs but also determine the distribution of goods, services and resources.

An economic slowdown may be due to factors on the demand side, or supply side or both. In this current crisis, it appears to have been caused by demand side factors when the financial crisis suddenly left many with no "money" (in lay person terms). It will be interesting to note that it was not caused by the supply side factors such as over-production, rising costs of production (and the accompanying consequences), etc.

When we say "demand", in economic terms we mean the desire to purchase something ie desire backed by the ability to pay. In other words, need or desire without the ability to pay is not "demand". Only when there is demand will there be supply of goods and services. Any supply of goods and services without demand will also slow down the economy and result in wastage of resources (meaning unemployment).

Demand, however can happen both on the consumer side and the producer side. Consumers demand for consumer goods and services while the producers demand for resources or the factors of production - land, labour, capital and enterprise.

If for example, the demand for houses increases, this will encourage entrepreneurs to venture into the housing construction industry. This means more resources in the country will now be diverted towards this industry. Engineers, architects, surveyors, construction workers, owners of land, "owners of capital" (banks), etc, etc will now be "employed" by this industry - meaning everyone here earns income. Income represents ability to pay which in turn means demand which in turn will lead to further production of goods and services to satisfy this demand. You can see that one act of employment leads to a multiplier effect in the economy.

Simple explanation of the multiplier effect: If you spend RM1, it is likely that you may spend 70 sen and save the 30 sen. B who gets your 60 sen may spend 40 sen, C in turn may spend 30 sen and so on. In this example, an investment of RM1 has created an income of 70 + 40 + 30 = RM1.40 sen. Imagine if 20 million people spend much income will have been generated in the country? This is why spending is important to spur the economy. What you spend becomes someone's income which then becomes someone else's income and so on.

The reverse is also true. If you DO NOT spend RM1, the economy shrinks by a "demultiplier" effect. Th economy shrinks rapidly. Resources become unemployed, businesses become pessimistic and cut costs, income levels drop unleashing a vicious cycle that will bring the economy to a recession.

The above is of course a very simple explanation. However, it is clear that spending is important when economy slows down and the AREAS in which spending is done is equally important if the main purpose is to create employment.


1 comment:

Anonymous said...

Mr Jahamy,

Thank you for the information and hopefully all the readers will appreciate, understand and practice them. I think that coming economic crisis will be worst than 1998.