How the Economy Works – Understanding the Basics [Explained]

An economy is a system where the agents of the economy interact with each other to establish trade. In an economy, multiple trades can happen at a time. There are three main agents at play: households, businesses, and the government. They interact when businesses offer employment/work to households to produce goods and services (G&S). The produced G&S are bought by the households to meet their needs. The government mainly plays the part of a policymaker who administers and controls the economy as per the established rules. For quick answers, read the FAQs.

Introduction

What is economy - for a layman

What is an economy? For a layman, the economy is like a “big game” that people play to buy and sell things. It is like, your family (a household) going for dinner in a restaurant (a business). Here, both entities are taking part in a little economy. On a bigger scale, there are multiple households and businesses buying and selling things simultaneously. They use the money to establish trade. A healthy economy in turn generates jobs and ensures income in the hands of people.

Video

How Does The Economy of a Nation Work?

How the economy works - Economy of a nation

A nation’s economy is a complex system that involves the production, distribution, and consumption of goods and services. At a basic level, it can be understood through the interaction of three main agents: households, businesses, and the government.

  • Households are the consumers of goods and services. They supply labor and other inputs to businesses. In exchange for work, they earn income.
  • Businesses are the producers of goods and services. They hire labor and other inputs from households to produce these goods and services for onward selling.
  • The government plays a role in regulating and providing public goods and services. They also work to redistribute income and wealth. Apart from the regulatory functions, it also collects taxes. The taxes so collected are used for the overall benefit of the economy. The government’s alternative source of income is the dividends they receive from their public sector companies (like ONGC, BHEL, IOCL, HPCL, etc).

In a market-driven economy, households and businesses interact to affect demand and supply. The price is the trigger that affects the demand and hence the supply.

The government also plays the role of the economy manager. They do it by taking policy decisions such as monetary policy and fiscal policy.

  • Monetary policy: Here the government controls the money supply and interest rates to influence economic activity.
  • Fiscal policy: Here the government spends money they’ve collected as taxes to stimulate the economy. It is done to meet the economic goals of the nation. Few goals can be like GDP growth or reducing income inequality.

Overall, the economy of a nation is a complex and dynamic system. But the main characters of an economy are households and businesses. The government has the role of a school principal. It keeps a watch and controls the economy to reach a common goal of a nation.

Examples to understand how the economy works

This is a step-by-step explanation of how the economy of a nation works, with examples:

  • Step #1: Households supply labor and other resources to businesses. In exchange, they take a salary from the work they render for the company. For example, a computer engineer might work at Google and receive a salary in exchange for his time and effort.
  • Step #2: Businesses use their resources, including what’s supplied by households, to produce goods and services. For example, Google might use their pool of engineers to develop a mobile phone like Google Pixel. Other resources of the company can be in the form of invested capital by shareholders. Google can use this capital to do R&D of the Pixel range.
  • Step #3: Households use their income to purchase and consume goods and services. For example, a teacher might use his salary to buy a Google Pixel phone, groceries, pay for healthcare, or spend on holidays.
  • Step #4: Businesses sell their goods and services to households and other customers. For example, a car manufacturer might sell its vehicles to individual consumers. A technology company like TCS can sell its software expertise to install cloud computing for a company like Britannia.
  • Step #5: The government provides public goods and services and regulates the economy. For example, the government might build roads and bridges to improve the infrastructure of its country. It can also provide basic education (Kendra Vidyalaya) and higher education (IITs, AIIMS, IIMs) to citizens to improve their working skills. It can also provide government hospitals to make healthcare services accessible to the underprivileged.
  • Step #6: Prices coordinate the interactions between households and businesses. For example, the price of a car signals to both the manufacturer and the consumer how much the car is worth and how much it should cost. If the price is too high, consumers may choose to buy a different car or hold off on their purchase, while the manufacturer may choose to lower the price or produce a different type of car.
  • Step #7: The government uses policies to manage the overall economy. For example, the government lowers interest rates to encourage borrowing. When borrowings rise, households and businesses spend more thereby enhancing the GDP growth rate. The government itself can decide to spend on infrastructure-building projects to create jobs and stimulate economic growth.

These steps and examples provide a basic overview of how the economy of a nation works. Experts might say that it is an oversimplified version of how the economy works. But this exemplified description of the economy can help beginners understand the basics of how economies function.

Now that we’ve understood what is an economy and how it works, let’s get deeper into the subject and explore what is an economic cycle.

An Economic Cycle

We have seen what is an economy. It is the system that produces, distributes, and consumes goods and services within a society. The system includes characters like households, businesses, government, and attributes like price, and policies.

On the other hand, an economic cycle refers to fluctuations in economic activity. While the economy is a continuous and ongoing system, economic cycles are characterized by periods of expansion (growth) and contraction (recession). These cycles can be influenced by the policies of the government. We’ll also talk about the role of debt that makes economies grow in cycles instead of linear growth.

The analogy of an economic cycle is a rollercoaster ride.

  • Economic Expansion:: Sometimes the economy is growing really fast. During such times lots of people have jobs and are making money. This is called an expansion.
  • Economic Contraction: Sometimes the economy slows down. During such times people start losing their jobs and businesses struggle. This is called a contraction.

These ups and downs happen over and over again. They can be influenced by things like government policies, market trends, and other factors. So, the economic cycle is like a big wave that the economy rides, and we all feel the effects of it.

By measuring the economic activity happening in a society, one will know if currently the economy is expanding or contracting. How to measure economic activity? By tracking indicators such as gross domestic product (GDP), employment, and inflation.

The Four phases of an economic cycle

how the economy works - an economic cycle
  • Growth: During the growth phase, economic activity is on the rise. People are spending more and hence businesses are producing more and making more sales and profits. As a result, the GDP of the country is also rising. During these times employment is increasing. Inflation also will rise as the demand for goods and services increases.
  • Peak: At the peak of the cycle, the economy has reached its maximum level of growth. The labor market will be tight, and inflation may also be at its peak. It is the time of maximum euphoria in the market.
  • Recession: During the recession phase, economic activity slows down, and households begin to get conservative and spend less. It lowers the demand for goods and services, hence businesses start producing less. The economy begins to shrink and GDP declines, unemployment rises. The businesses also make lower profits. Inflation is also falling.
  • Bottom: At the bottom of the cycle, the economy has hit its lowest point, minimum GDP, maximum unemployment, highest interest rates, and minimum inflation.

After the bottom, the cycle typically starts over again. The economy will see another period of growth. The length and severity of each phase can vary depending on a variety of factors, including government policies, market sentiments, global cues, etc.

The Role of Debt in Economic Cycles

Debt plays an important role in economic cycles. In fact, had there been no debt in the economy, the fluctuations between peak and bottom would have been insignificant. This means slower growth and a more subdued impact of the recession.

During the growth phase, the government keeps the interest rates low, hence the borrowing increase. Both the character of the economy, households, and businesses borrow more. Under the influence of debt, spending rise and as a result GDP also grows faster. This economic growth can contribute to rising asset prices, such as stocks and real estate prices.

Credit fuelled growth takes the GDP to its peak. However, as the economy reaches its peak, inflation also becomes too high. It needs taming, hence interest rates are hiked. Henceforth, a recession phase starts.

During the recession phase, business experience a dip in sales and profits. Hence, higher debts on their balance sheets become a problem. They find it difficult to repay their debts, leading to loan defaults and bankruptcies. Similarly, households face job losses and their debt repayment capability takes a hit. People start defaulting on their home loans, car loans, and personal loans. Not able to pay back the loan? What are the rules?

Loan payment defaults, both from households and businesses, make banks and NBFCs hesitant to lend money. During this cash crunch, spending is reducing fast and the GDP growth rate is also falling.

Economic cycles, fluctuations between peaks and bottoms, are more prominent due to the presence of debt in the economy. Why? Because debt-fuelled growth takes inflation to non-sustainable levels. Hence, the government forcefully tries to bring inflation to normal levels (interest rate hikes).

POV: The government has its inflation cut-off level. During a growth phase, interest rates are lowered too much and hence inflation crosses its cut-off levels. As a result, stronger actions are needed to tame inflation resulting in a severe recession phase. If the government can start controlling inflation as soon as it is about to reach the cut-off limit, managing recessions will be easier.

Understanding The Economy For an Equity Investor

From the perspective of equity investors, what should be the purpose behind knowing “how the economy of a nation works”? It is important for several reasons:

  1. Identifying investment opportunities: A deeper understanding of the economy can help investors identify potential sectors and industries for investment. Knowledge of economic cycles can give a perspective about if it is the current time to enter the market or if the future will offer better opportunities. For example, if an investor believes that the economy is entering a recession, they may decide to increase their holding in blue-chip stocks. During such times, such companies trade at better PE multiples.
  2. Assessing market risk: Economic cycles can have a significant impact on the equity market. Changes in economic conditions can affect corporate earnings and investor sentiment. Hence, by understanding the dynamics of the economy, investors can better assess the potential risks and opportunities in the market. For example, the growth phase is ideal for trading or profit booking. The recession phase is good for increasing holdings in quality stocks.

Overall, for equity investors, understanding how the economy of a nation works is a key component of making informed investment decisions.

Conclusion

The economy is a complex system to understand with full clarity. This article is written with the objective of simplifying the complex understanding of the economy.

It is essential to remember the key characteristics of an economy, households, businesses, and the government. From an economic point of view, these three characters are playing their part to make the country’s GDP grow at an acceptable pace. While doing so, it must also keep control of inflation (prices), and employment (income). Interest rate changes, taxation policies, and government spending help policymakers keep control of the economy.

One critical aspect of the economy is debt. The presence of debt highlights the four phases of an economic cycle: growth, peak, recession, and bottom. A controlled debt in the economy can work like an efficient growth trigger. But uncontrolled debt can lead to a financial crisis (like that of 2008-09). Therefore, it is essential to balance the benefits of debt with its potential risks. A country must have effective policies in place to manage debt and minimize the negative impacts of economic cycles.

FAQs

What is an economy and how does it work?

An economy refers to the system by which a society produces, distributes, and consumes goods and services (G&S). It works through the interactions between the producers of G&S (businesses) and consumers of G&S (households). The economy is regulated by influencing the demand and supply of the G&S. The government has the role of a regulatory and controller of the economy. It can also get involved in the process of G&S production and consumption by setting up public sector businesses and spending on infrastructure projects.

How do governments influence the economy, and what are their tools for doing so?

Governments influence the economy through fiscal and monetary policies. Fiscal policies involve government spending and taxation to influence economic activity. Monetary policies involve central banks regulating the money supply and interest rates to manage inflation.

How do businesses and households contribute to the economy?

Businesses contribute to the economy by providing goods and services. They also generate employment for the households. They also pay taxes which become the main source of income for the government. Similarly, households contribute by purchasing goods and services and paying taxes. They also contribute by buying assets such as real estate properties and financial instruments.

What are economic cycles, and how do they impact the economy?

Economic cycles are fluctuations in economic activity characterized by growth (expansion) and recessions (contractions). They impact the economy by influencing business cycles, employment rates, consumer spending, and inflation.

What is the role of debt in the economy, and how does it affect economic cycles?

Low interest-bearing debt can stimulate economic growth by enabling investment and spending. However, excessive debt can lead to high inflation. To tame inflation, debts are made expensive. As a result, debt taken by companies during the growth phase becomes a problem leading to defaults and bankruptcies. Thus, managing debt is crucial for sustaining economic growth and stability.

Have a happy investing.

>> NextShort-Term Debt Cycle

GoogleNews - GetMoneyRich

More Related Articles

Disclaimer: The information provided in my articles and products are for informational purposes only and should not be considered as financial or investment advice. Read more.

2 Responses

  1. Wow, what an informative article! I’m thoroughly impressed by the level of detail and insight provided. Thank you for sharing this valuable resource.

  2. Wow, what an informative article! I’m thoroughly impressed by the level of detail and insight provided. Thank you for sharing this valuable resource.

Leave a Reply

Your email address will not be published. Required fields are marked *