How a Country’s Economy Works
For most people, an economy sounds like a serious, complicated concept that they’ve only seen people in suits talk about on TV while pointing at their colorful charts. But at its very core, a country’s economy is something extremely simple, and people know more about it, and act a much more important role in its workings than they realize.
Simply put, the economy is comprised of people making things, buying things, selling things, and last but definitely not least, arguing about taxes. If you understand how money flows between people, businesses and the government, you already have a great understanding of the economy.
The Basic Idea
A country’s economy can be thought of as a giant game of passing the parcel to each other. The only difference from a normal game is that the parcel happens to be money and the game never ends. Money is moved around in a multitude of ways.
• People work their jobs and earn money for a living
• People spend their money on goods and services
• Businesses earn money when people purchase their goods and services
• Businesses pay workers and suppliers to keep it running
• Governments collect some of that cash (almost half in some cases)
As long as the money keeps moving around, the economy stays alive. This constant activity is what economists call “Economic Activity”.
The Main Players in an Economy
The economy consists of three main parties that contribute to its life. They are households, businesses as well as the government.
Households probably play the most important role of all. They provide labor to business while also spending money on food, housing, transport and perhaps a few subscriptions. They also pay tax to the government. Without households, nothing happens. There would be no workers or customers.
Business is the mitochondria of the economy. They are money-making and money-giving machines. While households may be the most important aspect, businesses facilitate them to move the economy. They produce goods and services, hire workers, pay wages and invest in machines, technology and expansion. From a roadside tea shop to massive multinational companies, businesses play a tremendous role in economic activity.
Governments play an important role in running the economy as well. They collect taxes, spend money on public services, create laws and regulations which will directly or indirectly affect the buying and selling power of goods and services which will affect the economy, and they also manage the overall economy.
Production
At the heart of any economy is production, which is making things people need or desire. This includes agriculture, manufacturing and services.
To produce anything, a number of factors are used. These factors of production are land (natural resources), labor (human effort), capital (machines, tools and factories) and entrepreneurship (people who take risks and start businesses). If a country is good at producing valuable goods and services in an efficient manner, a good economy will inevitably follow. If they don’t and rely heavily on importing, then everything gets expensive really fast.
Consumption
Consumption is just a fancy stuff for people buying goods and services. When people perform financial actions such as buying food, paying rent, using public or private transportation and subscription to various services, they keep businesses alive. Without consumers, profits vanish.
In almost every country, consumer spending makes up the largest percentage of the economy. This is why bad economies are so closely linked to crises. People don’t spend much during crises, which causes the economy to slow down in proportion. It is a chain reaction. No spending means no sales and no sales means no jobs and no jobs lead to panic and a market dip.
Money, Banks, and Credit
Money exists to make trade easier. Banks play a huge role in enhancing trade in a country by holding people’s savings, giving loans and creating credit. When banks give loans, businesses can expand, people can buy homes and governments can fund projects. Credit speeds up economic growth. However, it is important to note that too much debt can cause serious trouble.
Government Spending and Taxes
Governments need money to function, of course, and they have to collect taxes in order to do this. They collect income tax, sales tax, corporate tax and import duties. They spend this money on infrastructure, education, healthcare, defense and welfare programs (or at least they are supposed to),
If done well (which it seldom is), government spending boosts the economy by creating jobs and improving productivity. If done badly, you get expensive projects that are usually a front for some side hustles (money laundering).
However, it is important to collect a fair amount of tax without taking a major chunk of people’s incomes since it cripples their spending power.
Inflation
Inflation refers to prices rising over time. A little inflation over a long period is normal and healthy for the economy. It signifies that a demand exists. However, high inflation means that money loses value, savings shrink and people struggle to even afford the basics. Central banks often try to control inflation by adjusting interest rates and managing money supply. High interest rates slow spending while low interest rates encourage borrowing.
Trade
No country is isolated from the rest of the world (not even North Korea. They export and import goods too). Countries export goods that they are good at making and have a surplus while they import goods that they cannot produce cheaply. Exports bring in foreign currency and imports improve living standards. If a country imports a significant amount greater than what it exports, then problems such as trade deficits and currency pressure matter.
Economic Growth
Economic growth means the economy produces more value over time. This growth comes about through improving education, innovating better technology, investing in projects and companies, and efficient systems.
It is usually measured using GDP (Gross Domestic Product), which is the total value of goods and services produced in a country.
The higher the GDP, the higher the average income, more jobs and better living standards for people. However, this won’t matter if the wealth isn’t fairly distributed among the people.
Boom, Bust, Repeat
Economies move in cycles as proven by history time and time again. Economies expand, hit their peak, face a recession and then slowly recover. Recessions can happen due to financial crises, wars, pandemics and poor policies.
At the end of the day, a country’s economy isn’t magic.
It is simply people working, people trading, governments managing and businesses producing.