How does the economy work?

The economy is an intricate web of interactions that constantly shape how people live, work, consume, and more. It influences our entire world, from the prices of everyday goods and services to employment rates, nations' prosperity, and corporate giants' performance. However, despite its importance and influence, many see the economy as complex and enigmatic.

What is the economy?

The economy is a broad concept that involves the production, sale/purchase, distribution, and consumption of goods. It is a force that runs and maintains today's society. It includes companies, businesses, budgets, and everything else that aims to meet the demand from the public and other companies.

For example, one business that creates a certain product turns to another for the raw materials from which the product is made. They then sell it to a third business, which may add further value to the product, and eventually sell it to the end consumer. Consider it a chain of events. The supply and demand of any component affect the others.

Due to it being an all-encompassing term, it isn't easy to cover everything it includes. However, it is safe to say that it is responsible for running the world as we know it.

Who makes up the economy?

Everyone who spends money to buy products is a part of the economy. So is everyone who manufactures the product and offers it for sale. We all contribute to it in some capacity. That includes individuals, groups, businesses, and even entire governments. As such, all can be categorized into three sectors:

The primary sector

The primary sector is the one that deals with the extraction of natural resources. It includes mining metals and minerals, farming, cutting down trees, and alike. It produces raw materials, which are then shipped to the secondary sector.

The secondary sector

The secondary sector deals with processing, manufacturing, and producing. It uses raw materials to create products. Some of these products are then sold to the end user, while others are mere components of more complex products that require further manufacturing.

The tertiary sector

Finally, the tertiary sector is the one that covers a range of services, such as distribution and advertising. Some believe this sector can be split into quaternary and quinary sectors. These two sub-sectors were introduced to further distinguish between various tertiary sector services. However, the three-sector breakdown is generally the model that everyone has agreed to.

How does the economy work?

Understanding how the economy works is crucial for policymakers, economists, and business leaders. However, it is also helpful for everyone, as we are all affected by it. Therefore, we must understand economic theory and gain insight into the forces driving economic growth and systems. With that knowledge, you can make informed decisions, anticipate trends, and shape financial landscapes.

The first thing to note is that economies move in cycles of booms and busts. Essentially, they emerge, grow, reach their peak, and then gradually fall. After that, the cycle starts again.

The four phases of an economic cycle

The economic cycle is typically divided into these four stages:

• Economic expansion — The market is young, growing, and optimistic during the initial economic expansion phase. This phase usually comes after a crisis, giving everyone new hope. Demand for goods increases, company share prices rise, and unemployment drops. This leads to a rise in production, trade, investment, and consumption, ultimately boosting supply and demand.

• The Boom stage — This is the second phase of the cycle when production capacities are completely utilized. It is the phase that leads the economy to its peak. The price of goods and services stops increasing, there is some stagnation in sales, and smaller firms disappear through acquisitions, mergers, and alike. Interestingly, market participants remain positive, but the expectations are negative. The economy has reached its peak at the end of the boom phase.

• Recession — Recession is the third phase when the negative expectations from the boom phase start to manifest. The costs suddenly get higher, and the demand drops. The cost pressure on the companies themselves increases, so the profits tend to drop. The share prices also start to drop, leading to greater unemployment, the rise of part-time jobs, and drops in income. The spending decreases dramatically, and there is hardly any investment.

• Depression — Finally, the last phase is depression. It causes consistent pessimism among market participants, even when there are positive signals for the future. The depression often brings some sort of economic crisis. Companies suffer, their equity capital drops, interest rates on capital grow, and many businesses fail and file for bankruptcy. Once depression reaches its climax, the value of money also crashes. The rate of unemployment skyrockets, stock prices crash, and there is little to no investment.

Three types of economic cycles

While the previously mentioned four phases are typically consistent, their length can vary quite a bit. In fact, there are three types of economic cycles:

1. Seasonal Cycles — Seasonal cycles are the shortest of the three and usually last only a few months. Even so, their impact on the economy can still be strong. Its characteristics include seasonal changes in demand, impact on certain sectors of the economy, and certain predictability.

2. Economic Fluctuations — Economic fluctuations tend to last for years, resulting from an imbalance between supply and demand. This imbalance comes with a delay, so economic issues are not noticed until it is too late. They tend to have a powerful impact on the entire economy, which takes years to recover. This period is known for its unpredictability, irregularities of highs and lows, and the possibility of causing a severe economic crisis.

3. Structural Fluctuations — Structural fluctuations are the longest-lasting type, typically lasting multiple decades. They tend to happen due to technical and social innovations and their evolution. This is a generation-long cycle that no amount of savings can cover, and it tends to result in deep poverty and catastrophic unemployment levels. On the plus side, technological changes that follow tend to lead to greater innovation.

What factors influence the economy?

There are dozens, if not hundreds, of factors that influence the economy. Some influence it more, others less, but they all have at least some impact. Each purchase of any product contributes to demand. Meanwhile, on the macroeconomics scale, government policies can severely affect the economy of an entire country.

When discussing some of the most significant factors on the economy, we can consider the following:

Government policies

Using various policies, governments can severely impact the development of the economy. For example, fiscal policy allows governments to make decisions regarding taxation and spending. There is also monetary policy, referring to central bank activities that influence the quantity of money and credit in an economy. Through these tools, governments can stimulate economies or deflate overheated ones with purchasing power.

Interest rates

Interest rates represent the cost of borrowing money, which can strongly impact consumer spending and company investment. In numerous developed countries, borrowing money and then paying it back has become the way people interact with the world. Credits, or loans, are popular among consumers, allowing them to start businesses, buy cars or property, pay off college or medical debt, and more.

Naturally, lower interest rates mean that borrowing money is less expensive. This encourages more people to take out loans and spend money. That way, they help economic growth. However, borrowing becomes more expensive when interest rates are high, leading to less economic growth.

International trade

Another big contributor to the economy is international trade. As the name suggests, it signifies trade between different countries, where goods and services are exchanged, which can increase economic growth. If two countries have different resources, and each lacks what the other one has, they can both prosper through trading. However, this can have negative consequences, such as job losses in some industries.

Microeconomics vs. Macroeconomics

The broader economy can then be split into macroeconomics and microeconomics. Microeconomics focuses heavily on supply and demand and other factors that can determine price levels, such as the impact of GDP on unemployment rates. This is also where parts of the economy, such as individual markets, are taken into consideration.

In contrast, macroeconomics considers much larger interactions of these influences and is concerned with their effect on a larger scale. Microeconomics considers the performance of consumers, employees, and companies, while macroeconomics focuses on entire governments. It considers national consumption, trade balances, exchange rates, unemployment rates, and inflation. Ultimately, macroeconomics concerns itself with the global economy.

Unraveling the economic complexity

Saying that the economy is complex is a massive understatement. It is a living, constantly evolving aspect that determines the prosperity of any society and the world as a whole. Our exploration into "how does the economy work" has shed light on economic systems' intricate and interconnected nature. However, there is always more to learn and more details to explore.

FAQs

What is the economy?

The economy is a complex system revolving around producing, distributing, and consuming goods and services. It is a dynamic, constantly changing, and evolving system that includes all individuals, businesses, and governments worldwide.

How does the economy work?

The economy makes the world go round, but what fuels the economy is supply and demand. They are at the heart of it — consumers demand products, and producers create them. There are several factors that affect the economy, for example, government policies, interest rates and international trade.

What's the difference between microeconomics and macroeconomics?

Economies of the world are split into microeconomics and macroeconomics. Microeconomics deals with individuals, households, or single companies. Macroeconomics considers the economies of entire countries and how they affect one another.