How Does the Economy Work? (Simplified)

The economy impacts every aspect of our lives, from the food we consume to the people we elect to public office. Despite the economy’s reach, however, few people are able to grasp the full extent of its importance. We’ll break it down into basics for a clearer picture.

What Is the Economy?

Economic issues are crucial to our everyday lives. The term “economy” refers to everything aimed at the production, sale, distribution and consumption of goods. It comprises companies, businesses, private and public budgets: in short, everything that aims to meet the demand for goods and services. The economy is an all-encompassing term which covers — but is not limited to — the production of commercial products and the provision of various services.

How Do Economies Form?

The interaction between demand and supply forms the economy. When people work, they generally create tangible products. For example, cars are built, clothes are made and crops are grown.

The economy consists of sectors like construction, mining and automotive. It also includes services, which are activities at which people work without directly producing any products. Services include trade, transportation, banking and more. 

Together, sectors and services make up the economy. 

How Does the Economy Work?

Transactions and Purchase Cycles

Typically, economies go through cycles of booms and busts. The economic activities of a market are subject to cyclical fluctuations. The four phases of upswing, boom, recession and depression characterize the development of various economic variables within an economic cycle. Economic variables include gross national product, gross domestic product, degree of employment, price development and, in this context, rate of inflation. 

The economy reflects the overall transaction and purchase cycles of a market. Economic activity can be measured by different variables such as national product,employment levels and price developments. 

An economic cycle is divided into four phases:

• Economic upswing
• Boom
• Recession
• Depression

The economic cycle covers the entire period in which economic development goes through the individual phases, from one upswing to the next. Overall economic development occurs with a certain regularity. These economic fluctuations follow regular movements, or cycles, which may differ between sectors and industries. 

The economy and economic cycle are also influenced by fluctuations in economic variables, such as production rates, employment levels, interest rates and prices.

Types of Economic Cycles

Following are the three main types of economic cycles.

Seasonal Cycles

Seasonal cycles or fluctuations are economic trends that last only a few months, but often have a significant impact on an economy. The retail sector, for example, sees an uptick in sales during holidays, from Valentine’s Day to Christmas.

Characteristics of seasonal fluctuations include:

• Seasonal changes in demand
• Impact on individual sectors of the economy
• A certain degree of predictability to which entrepreneurs must adapt

Economic Fluctuations

Cyclical fluctuations usually last several years, and result from a delayed imbalance between the aggregate forces of supply and demand. In contrast to seasonal fluctuations, economic fluctuations affect the entire economy. Economic fluctuations are characterized by:

• Periodic (repetitive) highs and lows
• Time periods spanning several years
• A certain degree of irregularity
• Unpredictability
• Their influence on the entire economy
• The possibility of leading to serious economic crises
• Profound changes in demand which often lead to financial crises

Structural Fluctuations

Structural fluctuations are long-term, usually lasting between 40 to 60 years. They are brought about by technical and social innovations and their continued evolution. With technological changes, working capacities are freed up and can be used elsewhere, resulting in more innovations.

Phases of the Economic Cycle

The four phases of an economic cycle are detailed as follows:

Phase 1: Expansion

During the expansion phase, the positive mood of market participants creates optimistic expectations for the future. Usually, this phase comes after a crisis, and it’s often the result of economic and monetary stimulus measures employed by governments and central banks. Private demand for consumer goods increases and, among companies, the demand for capital goods. The gross national product also increases during this economic trend, as the production of companies increases and more jobs are created. Similarly, the share prices of listed companies rise. (Note that the stock market rises even when the economy stagnates, and only the central banks are creating money.)

The following characteristics are present during expansion:

• Declining unemployment rate
• Inventories decline as consumption increases
• Production once again increases to catch up with rising demand
• Stock market prices rise
• Prices in general rise steadily 
• General increases in household consumption

Phase 2: The Boom

The boom is considered to be the second phase of the economic cycle. Production capacities are completely utilized, and companies record impressive profits and sales. During the boom cycle, market participants are positive, yet expectations are negative. The boom and upper turning point in a business cycle display the following characteristics:

• No further price increases
• Stagnation in sales
• Smaller companies disappear from markets
• Consolidation processes through acquisitions of companies (takeovers, mergers, etc.)

At the height of the boom, the economy overheats, leading to a turnaround. Stagnation occurs as production rates can no longer be increased or sustained. The market becomes saturated, cutting off room for further growth.

Phase 3: Recession

A boom is followed by a recession, characterized by higher costs during the boom as demand slowly falls. The cost pressure on companies increases, and at the same time, profits shrink. Theoretically, this means that share prices are also falling, resulting in unemployment, more part-time (as opposed to full-time) jobs, and income reduction. The downturn is accompanied by a generally negative assessment of the economic situation by market participants. A recession displays the following characteristics:

• High stock prices
• No/hardly any investments made
• Decreased spending
• Labor market decline in overtime work, while the number of part-time jobs increases
• Declining stock market prices
• Potential increase in unemployment rates accompanied by lack of demand in the labor market
• Stagnating prices and fewer wage increases

Phase 4: Depression

In a depression, market participants are consistently pessimistic even as they see positive signals for the future. The depression phase can be described as a special case in the business cycle. It’s often accompanied by economic crises, as during the 2008 financial crisis. Companies suffer as their equity capital shrinks. At the same time, interest rates on capital rise, and more companies are forced into bankruptcy. At the height of a depression, the value of money plummets because of low interest rates.

The depression phase can be identified by these characteristics:

• Large rise in unemployment
• Rapidly falling stock prices
• Deflation
• Fewer or no investments being made
• Interest rates falling to record lows
• Growth of the informal economy

Microeconomics and Macroeconomics

In the study known as microeconomics, decisions of economic entities are analyzed against a background of individual benefit maximization. Households are faced with decision-making problems in the goods-services market, which are countered with a cost-benefit analysis. Due to the division of labor between different production processes, companies are faced with coordination problems involving various factors of production. Based on this approach, conclusions can be drawn regarding the allocation of resources:

• Microeconomics focuses on supply and demand and all other forces that determine price levels in the economy. For instance, macroeconomics examines the impact of GDP on the unemployment rate.
• In microeconomics, specific parts of an economy are taken into consideration, e.g., individual markets. In macroeconomics, one considers the larger interaction of these components and their effect on the whole.
• While microeconomics looks at individual actors, such as companies, macroeconomics focuses on entire governments.
• Actors considered in microeconomics are consumers, employees and companies. Microeconomics investigates the optimal distribution and use of goods, pricing, and maximization of benefits and profits for individual actors.
• Examples of considerations in macroeconomics are national consumption, unemployment rates and trade balances.
• In macroeconomics, the state’s actions play an important role. However, microeconomics does not take these larger considerations into account.
• In summary, macroeconomics examines the larger economic relationships between individual actors, while microeconomics examines the economic decisions of the actors themselves. 

Note that these two types of economics adopt very different approaches: microeconomics uses a “bottom-up” approach, while macroeconomics looks at the effect of national economic statistics and decisions on the population at large. Put simply, microeconomics deals with the economy on a small level, whereas macroeconomics deals with the economy on a larger scale.

Types of Economic Systems

An economic system is a mode of operation regarding the economic activity of a state. The economic system has an impact in particular on the management of a country’s production and the functioning of its labor market.

There are three types of economic systems:

• Planned economy
• Mixed economy
• Market economy (free enterprise)

These systems each have specific characteristics which can be influenced and adapted according to the economic and political situation of each country.

In theory, these three economic systems are distinct entities. In practice, however, it’s not always easy to tell them apart. Even if a state’s economy is described as “planned,” it can still display some features of a free enterprise or market economy. Conversely, a state with a free-market economy may possess some aspects of a planned economy.

For example, although the U.S. economy is largely based on private enterprise and market laws, the government’s participation in certain economic areas (such as regulating the price of certain goods) reflects its intervention in the country’s economy — because this type of intervention is more characteristic of a mixed economic system. The economy of the same state may be described as mixed in one sector and free market in another.

The Planned Economy

This economic system advocates the nationalization of means of production. The state determines the nature and quantity of production in advance. For example, in a planned economy, prices are set by the state, and production involves the intervention of the state in the economy. There is little or no room for private enterprise.

The Mixed Economy

In a mixed economy, both state and private enterprise have a role to play. Freedom of enterprise takes precedence, but the state also has a responsibility to intervene in the regulation and, sometimes, the nationalization of companies to achieve certain objectives. Today, the majority of Western countries run on a mixed economy.

Free Market Economy 

The free market economy is also called a free enterprise economy. Unlike a planned economy, in which the state determines what to produce, supply and demand (also called the laws of the market) dictate prices and the functioning of the economy in a free market economy. Free enterprise is associated with weak state intervention and the dominance of private enterprise.

Methods of Growing the Economy

Generally, the growth of any economy is determined by that of its GDP, which depends on how the country’s factors of production are used. These include capital, labor and total factor productivity. Capital refers to investments, while labor refers to the quantity of labor used, which is linked to the active population. Factor productivity encompasses the duration and quality of work, and the know-how accumulated by workers (referred to as human capital).

Labor Growth

Economic growth can be:

• Extensive: based solely on the growth of capital and labor
• Intensive: referring to more efficient use of the factors of production, based on productivity gains and economies of scale (for example, the industrialization of a geographical area)

Increased Investments

Investment in the economy is important for sustaining growth. Like labor, capital can grow extensively or intensively. A company makes its production decisions based on expected sales volume. When the economy is in an upswing, companies expect higher sales and will therefore increase production capacities. Companies hire new workers and invest in more machines, or upgrade their current equipment. Raw materials or intermediate goods may also be acquired. 

Increased Consumption

Consumption is the ultimate driver of demand in the economy. The greater the levels of consumption (government spending and consumer spending), the more likely an economy is to thrive.

What Impact Does the Economy Have?

One of the lasting effects of globalization is that the world’s economy has consequences for everyone, both local and global: households, governments and the international community. 

Local vs. Global Economy

The local economy is the economy of an individual country,ranging from household consumption to investment decisions based on inflation and interest rates. This type of economy benefits only its residents. 

On the other hand, the economy of a country interacts with other international economies. The impact of this global economy is primarily on import and export activities. With technological advancement, the global economy also affects the number of investments and foreign exchanges made. 

What Is Debt, and Is it Okay?

Public debt corresponds to all public loans contracted by the state, social security, various central government bodies and local authorities. 

Public debt can have positive effects if the loans are used to finance public investments, such as infrastructure, unemployment benefits, healthcare, etc. Such spending increases the growth potential of an economy in the medium term. Ideally, this means that the state can then reduce its deficit again by increasing tax revenues.

Even in exceptional economic situations, borrowing can be useful in order to compensate for losses in demand on the part of companies and consumers.

Negative effects of public debt include rising interest and repayment obligations, which can increase calls for austerity measures. On the other hand, increasing government borrowing risks displacing private loans and investments from the market. The result can have correspondingly negative consequences for economic growth.

Short-Term Debt Cycle

Also known as the business cycle, the short-term debt cycle is characterized by the presence of cheaper money in the economy due to lower interest rates. This effectively encourages consumption in the economy, resulting in increased demand and a rise in inflation, ultimately paving the way for the four business cycles discussed earlier. Interest rates and inflation are the primary factors which influence the short-term debt cycle.

Long-Term Debt Cycle

Note that each short-term debt cycle typically ends with more growth and debt than the previous one. This means that debt increases faster than incomes over long periods, which causes the long-term debt cycle.

During a long-term debt cycle, people may be getting more and more loans despite rising economic debt. Why? Quite simply, because they think things are going well. Humans tend not to have good long-term memories — when things are going well, we choose to focus on the positives, such as increased incomes, booming stock markets and spiking real estate prices, etc. This can lead to impulsive/spur-of-the-moment decisions.

It’s worth investing in certain goods, services and financial assets with borrowed money. For instance, housing is a necessity for everyone, and you may want to buy an apartment to live in. In this case, taking out a bank loan is perfectly justifiable. 

However, if as a society we rely too much on credit, a bubble may begin to develop. Eventually, this can result in a debt burden that must be reduced by means other than a reduction in interest rates. According to American investor Ray Dalio, there are four ways to achieve this reduction:

1. Reduction of expenses (individuals, companies and governments)
2. Restructuring or defaults, and thus reduction of debt
3. Redistribution of wealth
4. Printing of new money by the central bank

Unlike the short-term debt cycle, the long-term debt cycle occurs over a much longer period of 50 to 75 years. It is driven primarily by the accumulation of public and private debt. 

Inflation vs. Deflation

Inflation describes a general price increase without a commensurate increase in value. There are several causes of inflation. Supply inflation is characterized by higher/rising prices of production factors, such as raw materials, or a rise in wages and non-wage costs. This makes the manufacturing processes of many goods more expensive. Companies pass on additional costs to consumers by increasing their prices. As a result, purchasing power decreases over time. 

Deflation is the opposite of inflation. It’s defined as a general price decline over time, typically caused by a decrease in spending. As spending decreases, deflation can be accompanied by a recession. One solution is to lower interest rates. By lowering the interest rates on loans, lenders encourage more borrowing. Then, when more credit is available, the government expects the parties within its economy to increase their spending.

Supply vs. Demand

Supply is the quantity of goods and services available in the market for sale or exchange. It corresponds to the quantity of goods sellers offer on the market, which can be raw materials, products or services. Demand is the intention of households and companies to buy a good or service at a certain price. The demand-and-supply relationship creates market equilibrium. 

Capitalism vs. Socialism

Theoretically, the primary difference between capitalistic and socialistic economies is the degree of government control involved.

Capitalism is often likened to a free market economy. This economic system is characterized by private ownership of the means of production and the profit generated from them. To achieve the greatest possible profit, entrepreneurs produce goods that meet the wishes of consumers. Ideally, prices are determined by the market forces of supply and demand. 

Socialism, on the other hand, is an economic system in which factors of production are owned and controlled by the state. This means that the government controls production and regulates prices to meet consumer needs.

The Bottom Line 

We hope you’ve found this guide informative. It’s important to learn about the economy and how economic cycles work, so you can appreciate money more and make better investments. With the information available online, you can learn anytime, anywhere — and put the financial knowledge you acquire to good use.