What is the Economy and How does it work?

What is the Economy and How does it work

You must be wondering what the is Economy and Why you need to understand the Economy? A great investor not only understands the market economy but also analyses it to his benefit.

While most of us know what it is, we have never made an attempt to understand, analyze it inside out.

Therefore, today I’ll be talking about how the economy functions.

Why?

Because understanding the economy is as essential as understanding how your personal finance works.

It is important to study the past, present, and future of the economy.

It is commonly said that if you know about the past, you are better prepared for the future.

Studying the economy will equip you with a fair ability to judge what is happening in the economy now, what is likely to happen in the future and most importantly, how you should act in these situations.

Let’s move on.

The Economy resembles a Machine

Like any machine whatsoever, the economy also has cause-effect relationships.

That is, for every action, there is an equal and opposite reaction.

Also, the economy works like a video being played on a loop!

If you observe it long enough, you will notice that the same events repeat themselves again and again.

What is the Economy?

What is the economy

In very simple terms, an economy is an amalgamation of three things: goods, services, and an exchange system.

Goods are physical products.

Services are intangible goods.

Earlier, the exchange system used to be a barter system. Now it is a system in which one thing of value is used to ‘pay’ for things. This thing of value is … cash!

So, an economy is just the aggregate of the considerable number of transactions that make it up. 

So, rather than studying and understanding the economy from top to bottom, we will adopt the bottom to top approach.

What does this mean?

This means that we will begin small. We will first look at a single transaction and then move up progressively.

This way, you will be able to understand the various aspects of the economy much better.

This unique way of looking at the economy will ensure that you have a greater grasp on the possible ups and downs of the economy.

Productivity Growth

Productivity growth - what is economy

Productivity growth is measured in terms of GDP.

This means that you take the country’s Gross Domestic Product (GDP) that is the added value of ALL the possible goods and services in the country and then divide it by the number of citizens residing in the country.

Look at the GDP growth graph of any country and you will probably notice one thing: the graph will be rising gradually.

This implies that the country, and of course its people are getting wealthier year after year after year.

What? How? 

Why does productivity grow?

Because information and knowledge are constantly increasing.

1 mobile phone is better than a torch, calculator, calendar, camera, and the list will go on and on.

1 excel sheet is better than 10 calculators.

You get the idea, right?

All this infinite increase in information has raised the standard of living and productivity.

By now, you must understand that productivity is the most important aspect that matters in the long run.

Obviously, the economy will have good days and bad days, but with a steady level of productivity in place, we can be sure of one thing: that the economy will refocus.

It all starts with YOU

Okay, so let’s zoom into the economy a little.

Okay, little more.

Yes, this is fine.

Everything in the economy starts with YOU.

It all starts when you buy something. Anything.

Yes, you. 

What is a Transaction?

what is a transaction, how it shapes economy

A transaction is an exchange comprising of a buyer, seller, good/service and cash/credit.

Cash

Cash is money. (And money is cash, obvs!)

Cash is the thing that enables you to settle a transaction.

For instance, somebody gives you a lemon, you give them cash – and then the transaction is settled.

Credit 

Credit is nothing but a simple promise to pay your money in the future.

For instance, in the event you pay for a lemon with your credit card, the transaction isn’t settled. 

Why?

Because you are still to pay.

Most of the spending in an economy originates from credit.

Why?

Because it does not take the effort to create credit. You simply have to swipe your card.

Credit is the thing which creates economic cycles:

Whenever credit is easily available, there is economic expansion.

Whenever there is a crunch for credit, there is a recession in the economy.

Markets

A market is an intangible sort of thing in which buyers and sellers indulge in transactions.

There is a market for everything. 

You name it, and there is a market for it.

In fact, you know the thing’s name because it is being sold in the market.

Set up all the markets together, and voila! You have the economy!

Price 

The true price of anything can be obtained by calculating the total spending (in cash and in credit) on a particular product and then dividing it by the total number of units sold by the market, which is all the merchants.

what is an economy - prices

Price = Total Spending (Cash + Credit)/Total Units Sold

Price, an important component of the economy, affects two things:

  1. Inflation: This happens when there is a sustained rise in prices.
  2. Deflation: This happens when there is a sustained fall in prices.

Government

The government plays a significant part in the economy.

Each person functions individually in the economy. But there must be someone who must ensure that all individuals function fairly. This part is played by the government.

Not just this, they likewise need to ensure terrible things don’t occur to the economy. What’s more, if awful things occur, they ensure that appropriate solutions are worked upon.

Reserve Bank of India is responsible for the financial functioning of India.

Buying

You are a buyer in the economy. 

But a tiny buyer in the economy. The government is the largest buyer in the economy.

Buying can be either done from:

  • The private sector
  • The government

Summary

Congratulations! You have successfully comprehended the nuts and bolts of the economy.

Now that you have reached the end of this article, you know the several tiny pieces that make up this economy.

You also know that productivity is always increasing. And, that’s what matters in the long, long run.

The sole objective of an economy is to build productivity.

In fact, if you are planning to become wealthy anytime soon, your goal must be to increase your productivity.

However, this is only half a picture.

An economy is a vast machine and it is impossible to understand it wholly in a single day.

Every day, there is something new happening here.

Every day, there is something old repeating itself here.

So, all in all, today we learned:

  • An Economy is a machine
  • Productivity matters the most
  • Markets, buyers, transactions’ role in the economy

I hope you enjoyed reading this.

Keep following Bachat for more such finance-related discussions.

Take care!


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