How Does the Economy Work?

shironosov/iStock/GettyImages

The U.S. economy today works in ways that are both simple and complex. On the one hand, there are straightforward rules and patterns governing transactions and debt cycles. On the other hand, humans make emotional and irrational decisions about how to spend their money, with individual consequences that add up to macroeconomic events. An economist's job is to look at all of these variables and come up with theories and explanations that are relevant as well as understandable.

TL;DR (Too Long; Didn't Read)

A simple explanation of how the economy works breaks down economic activity into a combination of transactions, credit, productivity increases and short- and long-term credit cycles.

How Transactions Work

A transaction is an exchange of money for goods or services. The seller provides the goods or services and the buyer provides the cash or cash equivalent that is exchanged for the goods or services. The seller earns income in exchange for providing the goods or services to the buyer. The transaction creates a debit for the buyer, who has less money after it is completed, and it creates a credit for the seller, who ends up with additional money.

An economy grows and thrives through ongoing transactions, which are the primary vehicles for earning money. The more transactions take place, the greater the GDP, or sum total of money exchanged. Transactions keep money flowing by transferring it from one party to another.

Work is a transaction as well, involving the exchange of time and labor for money, which can then be exchanged again for goods and services via additional transactions. Even if the same money is being exchanged over and over again, the more transactions that take place, the greater the amount of wealth and economic activity.

The Role of Debt

Not all transactions are based on direct exchanges of cash. Credit is the system of financing transactions either between the parties making an exchange or through an outside party such as a bank. From a transactional standpoint, buying with credit is the same as buying with cash because the same money changes hands for the same product. From the standpoint of the greater economy, debt drives economic growth by making more money available for individuals and businesses to spend.

Without debt and credit, people could only spend as much as they earn. Although this sounds like a sound proposition from the perspective of personal financial health, it puts the economy at risk by limiting purchasing, which fuels income growth more broadly. Purchasing leads to income and prosperity, even though the ones who prosper aren't necessarily the ones spending the borrowed money.

Debt is made up of principal and interest. Principal is the amount that was borrowed and will need to be repaid, and interest is the amount that the lender charges for the service of providing the cash to borrow, the fee for renting money, in effect. The process of financing debt is in itself a transaction because the borrower pays the lender for the product or the borrowed money.

Productivity as a Strategy

While debt and credit are somewhat artificial (and even problematic) ways to create wealth, productivity is a sound and dependable strategy. Credit increases purchasing power by creating a situation (debt) that will eventually have to be addressed. You can only spend more than you earn for a limited amount of time before your financial obligations catch up with you and you have to devote your resources to repayment, which gets you out of debt but doesn't help the broader economy. In contrast, increased productivity builds real wealth by increasing production relative to investment and work.

When a business increases productivity, it increases its output during a given amount of time, increasing profits and margins. Productivity can come from time-saving equipment, which is itself an investment that helps the economy through purchasing. Productivity can also come from improved systems, which can sometimes be as simple as rearranging a sequence of tasks and leveraging the efficiencies that come with this change.

Short-Term Debt Cycles

When you accrue debt, you're spending more than you earn. This overspending can't go on indefinitely, and it's just a matter of time before you have to start paying the money back by earning more than you spend. Although money flows out of your bank account when you repay debt, this exchange is different from a purchase of goods or services that helps the economy grow. Debt repayment pays for goods you have already bought and therefore doesn't bring corresponding income to someone else.

Individuals tend to experience short-term debt cycles of borrowing and spending money, and this individual financial activity eventually adds up to larger national and international trends. The supply of money is finite, although the Federal Reserve, the country's central bank, can stimulate the economy by authorizing more money to be put into circulation. But printing money can eventually lead to inflation because oversupply brings down the value of currency.

The Federal Reserve can also regulate debt and spending by raising interest rates, making it more expensive to borrow money and slowing down the rate at which it changes hands. This is usually in response to inflation, and higher interest rates generally do cool down rising prices. Rising interest rates lead to a recession, a necessary contraction of the economy. This usually takes place every five to 10 years and can be difficult for individuals and communities, although economists see it as ultimately beneficial for the economy as a whole because it allows prices and economic activity to stabilize.

Long-Term Debt Cycles

The short-term economic corrections that take place during recessions are usually temporary measures that address symptoms rather than root causes. Although short-term rises in interest rates cause people to spend more slowly, they are still spending money and the Federal Reserve usually lowers interest rates again as soon as it is feasible to do so. The cumulative effects of longer-term debt financing add up to a situation that grows increasingly untenable. This happens approximately every 75 years.

Much of the debt that has accrued went toward paying for expenditures whose value is subjectively determined, such as real estate and stock. As people begin spending more of their money on servicing debt and less of their money on purchases that will help the economy by putting money in someone else's pocket, there is less money to go around and the cost of these subjectively valued assets starts to fall. There are more homes and stocks for sale than there are people to buy them. People start feeling less affluent and hold off on spending money even if they aren't destitute.

While the Federal Reserve can help the economy through a short-term debt cycle by lowering interest rates and getting money flowing, this is more difficult with the nadir of a short-term debt cycle because the problem is deeper and more widespread. Interest rates may already be as low as they can go, so people are likely to hold on to their cash rather than making risky investments. Like a short-term debt cycle, a long-term debt cycle is a necessary correction, but an even more painful one.

The Meaning of De-Leveraging

There are a number of strategies that the Federal Reserve can draw on to lift the economy out of the depth of a long-term debt cycle. None of the strategies are enough on their own, but a well-coordinated mix can lead to an economic upturn, although the transition takes time.

  • Decreased spending. Austerity measures are problematic but necessary for dealing with the consequences of the long-term debt cycle. Because debt, or spending money that hadn't yet been earned, has led to a shortage of available capital, it is necessary to spend less and pay back some of these accrued liabilities. On the other hand, decreased spending can make a depression or recession worse because less money is circulating to help rebuild wealth.

  • Reduced debt. Debt reduction will ultimately free up funds for the next economic expansion. Debt can be reduced through repayment, but this process also diverts funds from the spending which will help to revitalize the economy. Debt can also be forgiven or negotiated down so some, but not all of it will be repaid. This approach leads to short-term losses but can contribute to long-term gains.

  • Wealth redistribution. Recessions and depressions can be socially turbulent times because less affluent people feel the brunt of the situation more acutely. In addition, depressions and recessions are often characterized by an increase in wealth among the wealthy alongside a declining standard of living among the poor. Social programs such as the New Deal and increased taxes for people who can afford to pay more help to get money flowing and level the playing field somewhat.

  • Printing money. If there isn't enough money to go around, the Federal Reserve can alleviate the shortfall by authorizing more to be printed and put into circulation. If this is done recklessly it can lead to uncontrolled inflation, as in Germany during the 1930s. However, when increases in productivity can accompany the extra available cash, a positive feedback loop occurs.

A Snapshot of GDP

The gross domestic product of an economy is the sum of all of the economic activity in a particular country or region during a particular time frame, such as a year. This economic activity can be measured by adding up all of the production that takes place. This approach emphasizes the value that is being added to raw materials in the form of productivity.

GDP can also be calculated by aggregating all of the money that has been spent on goods and services at the retail level. This does not include wholesale purchases, which will ultimately be sold to end-users. Economists can also calculate GDP by looking at income, or the amount that all of an economy's workers are paid to do all of that economy's work.

GDP: A Rough Measure of Activity

GDP is a useful, but rough, measure of economic activity. When it encompasses all of the money that is spent at the retail level, it does not reflect how much cash is actually available because it measures the same units of currency being spent over and over again.

In addition, a measurement of how much money is being spent does not provide any information about whether these expenditures are contributing to quality of life. In fact, a rapidly growing GDP can actually lead to decreased quality of life if the economic activity requires employees to be overworked or if the increased economic activity comes with a price of environmental degradation.

Using a straight figure as a measure of economic activity can also be misleading because a dollar at the present time is worth less than it was at an earlier point in time. Real GDP is an adjusted figure that also reflects the value of the money spent, earned or exchanged relative to the rate of inflation. It is used to compare GDP numbers over time.

References

Resources

About the Author

Devra Gartenstein founded her first food business in 1987. In 2013 she transformed her most recent venture, a farmers market concession and catering company, into a worker-owned cooperative. She does one-on-one mentoring and consulting focused on entrepreneurship and practical business skills.