How does an economy work?
An economy is usually seen as a complex machine made up of millions of moving parts and mechanisms working together to serve all people and institutions within that ecosystem.
However, if we view the economic system from a broader and more simplistic perspective, we can improve our understanding of how the economy functions.
Transactions are the foundational stone of the economy.
These transactions are exchanges of money or credit between buyers and sellers for goods, services or assets. All participants in an economy (people, business, institutions and the government) engage in transactions. It is clear that since transactions are the way to participate in an economy, they are the drivers of all economic forces.
A market is a platform where transactions for the same things are repeated continuously. For example, the gold market, the bond market, the stock market, etc.
The two major institutions which exercise control over the markets, and the economy in general, are the Central Government and the Central Bank. The government collects and manages taxes and does public expenditure. This is known as fiscal policy. The Central Bank controls the volume of money in an economy and manages the interest rates. This is called monetary policy.
Credit and debt are a critical concept to understand as it is through credit that lenders make their money and borrowers get the money to buy things, or to invest, which they couldn’t afford to beforehand. The amount of credit directly affects spending in an economy. If borrowings are increased, they will lead to increased consumption, which will lead to a rise in incomes (because spending for one person is an income to another), which will, in turn, result in more borrowings. Overall, this process leads to economic growth
As people get more and more credit, they have the ability to consume more than they produce. However, in the future, they have to repay this debt, and they will have to produce more than they consume in order to do that.
Thus, an economy with credit expands (due to more spending and increased incomes) in the short run, and then it recedes when the debt is repaid, and the central bank increases the interest rates to control inflation (inflation increases due to increased spending and demand for goods). Higher interest rates lead to lesser borrowings, which results in reduced spending, a dip in income levels and then recession.
As the economy grows, people continue to push the highs and lows of the cycle. In the upward curve, incomes are rising in tandem with the debt, so the debt burden continues to remain manageable. However, at its peak, the debt burden in comparison with the income increases and come to a boiling point. This is where the downward curve starts. Debt repayments rise faster than incomes. Since people are repaying their debts, overall spending in the economy is reduced. This leads to a decrease in income levels.
During this period, due to low spending and borrowings, the debt burden reduces. Businesses and organization face a cash crunch and they try to reduce their costs by laying off the workers. Unemployment rate skyrockets, and a lot of participants of the economy default on their debts. The government’s budget deficit also rises substantially as it tries to redistribute resources.
The government and the Central Bank cooperate to manage the economy in a time of crisis and facilitate its recovery. This may be in the form of lowering down taxes, increased infrastructure spending and/or reduced interest rate.
The economy works in cycles and understanding these cycles can be an important part of the investment process. Usually, if you can get a sense of the peak or trough of a cycle that can help avoid investment mistakes.