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Understanding the Basics: How the

Economy Works Explained
Kiran M + Follow
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Published Mar 6, 2023

What is an economy? For a layman, the economy is like a “big game” that people
play to buy and sell things. It is like, your family (a household) going for dinner in a
restaurant (a business). Here,Sign in to view
both entities more
are taking part in a little economy. On a
content
bigger scale, there are multiple households and businesses buying and selling things
simultaneously. They use the money to establish trade. A healthy economy in turn
Create your free account or sign in to
generates jobs and ensures income in the your
continue hands of people.
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How Does The Economy of a Nation Work?

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A nation’s economy is a complex system that

Continue involves
with Google the production, distribution,
and consumption of goods and services. At a basic level, it can be understood
through the interaction of three main
New agents: households,
to LinkedIn? Join now businesses, and the
government.

Households are the consumers of goods and services. They supply labor and other inputs
to businesses. In exchange for work, they earn income.

Businesses are the producers of goods and services. They hire labor and other inputs from
households to produce these goods and services for onward selling.

The government plays a role in regulating and providing public goods and services. They
also work to redistribute income and wealth. Apart from the regulatory functions, it also
collectsLike Comment
taxes. The taxes so collected Share
are used for the overall benefit of the economy. 4The
 government’s alternative source of income is the dividends they receive from their public
sector companies (like ONGC, BHEL, IOCL, HPCL, etc).

In a market-driven economy, households and businesses interact to affect demand

and supply. The price is the trigger that affects the demand and hence the supply.

The government also plays the role of the economy manager. They do it by taking
policy decisions such as monetary policy and fiscal policy.

Monetary policy: Here the government controls the money supply and interest rates to
influence economic activity.

Fiscal policy: Here the government spends money they’ve collected as taxes to stimulate
the economy. It is done to meet the economic goals of the nation. Few goals can be
like GDP growth or reducing income inequality.

Overall, the economy of a nation is a complex and dynamic system. But the main
characters of an economy are households and businesses. The government has the
role of a school principal. It keeps a watch and controls the economy to reach a
common goal of a nation.

Examples to understand how the economy works

This is a step-by-step explanation of how the economy of a nation works, with

examples:

Step #1: Households supply labor and other resources to businesses. In exchange, they
take a salary from the work they render for the company. For example, a computer
engineer might work at Google and receive a salary in exchange for his time and effort.

Step #2: Businesses use their resources, including what’s supplied by households, to
produce goods and services. For example, Google might use their pool of engineers to
develop a mobile phone like Google Pixel. Other resources of the company can be in the
form of invested capital by shareholders. Google can use this capital to do R&D of the
Pixel range.

Step #3: Households use their income to purchase and consume goods and services. For
example, a teacher might use his salary to buy a Google Pixel phone, groceries, pay for
healthcare, or spend on holidays.

Step #4: Businesses sell their goods and services to households and other customers. For
example, a car manufacturer might sell its vehicles to individual consumers. A technology
company like TCS can sell its software expertise to install cloud computing for a company
 like Britannia.

Step #5: The government provides public goods and services and regulates the economy.
For example, the government might build roads and bridges to improve the infrastructure
of its country. It can also provide basic education (Kendra Vidyalaya) and higher education
(IITs, AIIMS, IIMs) to citizens to improve their working skills. It can also provide government
hospitals to make healthcare services accessible to the underprivileged.

Step #6: Prices coordinate the interactions between households and businesses. For
example, the price of a car signals to both the manufacturer and the consumer how much
the car is worth and how much it should cost. If the price is too high, consumers may
choose to buy a different car or hold off on their purchase, while the manufacturer may
choose to lower the price or produce a different type of car.

Step #7: The government uses policies to manage the overall economy. For example, the
government lowers interest rates to encourage borrowing. When borrowings rise,
households and businesses spend more thereby enhancing the GDP growth rate. The
government itself can decide to spend on infrastructure-building projects to create jobs
and stimulate economic growth.

These steps and examples provide a basic overview of how the economy of a nation
works. Experts might say that it is an oversimplified version of how the economy
works. But this exemplified description of the economy can help beginners
understand the basics of how economies function.

Now that we’ve understood what is an economy and how it works, let’s get deeper
into the subject and explore what is an economic cycle.

An Economic Cycle

We have seen what is an economy. It is the system that produces, distributes, and
consumes goods and services within a society. The system includes characters like
households, businesses, government, and attributes like price, and policies.

On the other hand, an economic cycle refers to fluctuations in economic activity.

While the economy is a continuous and ongoing system, economic cycles are
characterized by periods of expansion (growth) and contraction (recession). These
cycles can be influenced by the policies of the government. We’ll also talk about
the role of debt that makes economies grow in cycles instead of linear growth.

The analogy of an economic cycle is a rollercoaster ride.

 Economic Expansion:: Sometimes the economy is growing really fast. During such times
lots of people have jobs and are making money. This is called an expansion.

Economic Contraction: Sometimes the economy slows down. During such times people
start losing their jobs and businesses struggle. This is called a contraction.

These ups and downs happen over and over again. They can be influenced by things
like government policies, market trends, and other factors. So, the economic cycle is
like a big wave that the economy rides, and we all feel the effects of it.

By measuring the economic activity happening in a society, one will know if currently
the economy is expanding or contracting. How to measure economic activity? By
tracking indicators such as gross domestic product (GDP), employment, and
inflation.

The Four phases of an economic cycle

Growth: During the growth phase, economic activity is on the rise. People are spending
more and hence businesses are producing more and making more sales and profits. As a
result, the GDP of the country is also rising. During these times employment is
increasing. Inflation also will rise as the demand for goods and services increases.

Peak: At the peak of the cycle, the economy has reached its maximum level of growth. The
labor market will be tight, and inflation may also be at its peak. It is the time of maximum
euphoria in the market.

Recession: During the recession phase, economic activity slows down, and households
begin to get conservative and spend less. It lowers the demand for goods and services,
hence businesses start producing less. The economy begins to shrink and GDP
declines, unemployment rises. The businesses also make lower profits. Inflation is also
falling.

Bottom: At the bottom of the cycle, the economy has hit its lowest point, minimum GDP,
maximum unemployment, highest interest rates, and minimum inflation.

After the bottom, the cycle typically starts over again. The economy will see another
period of growth. The length and severity of each phase can vary depending on a
variety of factors, including government policies, market sentiments, global cues, etc.

The Role of Debt in Economic Cycles

Debt plays an important role in economic cycles. In fact, had there been no debt in
the economy, the fluctuations between peak and bottom would have been
insignificant. This means slower growth and a more subdued impact of the
recession.

During the growth phase, the government keeps the interest rates low, hence the
borrowing increase. Both the character of the economy, households, and businesses
borrow more. Under the influence of debt, spending rise and as a result GDP also
grows faster. This economic growth can contribute to rising asset prices, such as
stocks and real estate prices.

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Credit fuelled growth takes the GDP to its peak. However, as the economy reaches
its peak, inflation also becomes too high. It needs taming, hence interest rates are
hiked. Henceforth, a recession phase starts.

During the recession phase, business experience a dip in sales and profits. Hence,
higher debts on their balance sheets become a problem. They find it difficult to
repay their debts, leading to loan defaults and bankruptcies. Similarly, households
face job losses and their debt repayment capability takes a hit. People start
defaulting on their home loans, car loans, and personal loans. Not able to pay back
the loan? What are the rules?

Loan payment defaults, both from households and businesses, make banks and
NBFCs hesitant to lend money. During this cash crunch, spending is reducing fast
and the GDP growth rate is also falling.

Economic cycles, fluctuations between peaks and bottoms, are more prominent due
to the presence of debt in the economy. Why? Because debt-fuelled growth takes
inflation to non-sustainable levels. Hence, the government forcefully tries to bring
inflation to normal levels (interest rate hikes).

POV: The government has its inflation cut-off

level. During a growth phase, interest rates are
lowered too much and hence inflation crosses its
cut-off levels. As a result, stronger actions are
needed to tame inflation resulting in a severe
recession phase. If the government can start
controlling inflation as soon as it is about to reach
the cut-off limit, managing recessions will be
easier.

Understanding The Economy For an Equity Investor

From the perspective of equity investors, what should be the purpose behind
knowing “how the economy of a nation works”? It is important for several reasons:

1. Identifying investment opportunities: A deeper understanding of the economy can help

investors identify potential sectors and industries for investment. Knowledge of economic
cycles can give a perspective about if it is the current time to enter the market or if the
future will offer better opportunities. For example, if an investor believes that the economy
is entering a recession, they may decide to increase their holding in blue-chip stocks.
During such times, such companies trade at better PE multiples.

2. Assessing market risk: Economic cycles can have a significant impact on the equity
market. Changes in economic conditions can affect corporate earnings and investor
sentiment. Hence, by understanding the dynamics of the economy, investors can better
assess the potential risks and opportunities in the market. For example, the growth phase
is ideal for trading or profit booking. The recession phase is good for increasing holdings
in quality stocks.

Overall, for equity investors, understanding how the economy of a nation works is a
key component of making informed investment decisions.

Conclusion

The economy is a complex system to understand with full clarity. This article is
written with the objective of simplifying the complex understanding of the economy.

It is essential to remember the key characteristics of an economy, households,

businesses, and the government. From an economic point of view, these three
characters are playing their part to make the country’s GDP grow at an acceptable
pace. While doing so, it must also keep control of inflation (prices),
and employment (income). Interest rate changes, taxation policies, and government
spending help policymakers keep control of the economy.

One critical aspect of the economy is debt. The presence of debt highlights the four
phases of an economic cycle: growth, peak, recession, and bottom. A controlled debt
in the economy can work like an efficient growth trigger. But uncontrolled debt can
lead to a financial crisis (like that of 2008-09). Therefore, it is essential to balance the
benefits of debt with its potential risks. A country must have effective policies in
place to manage debt and minimize the negative impacts of economic cycles.
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