A Quick Look at How the Economy Works – Introduction
Regardless of the type of trader that you are, having a good understanding about how the economic machine works is very important. It is important because having this knowledge can help you navigate the market and how to forecast the market. This article will explain how the economy works.
The first part of any economy is on production. This is a process in which the raw materials are produced. In this process, the farmers and miners produce the raw materials. After this, they sell their produce to manufacturers. To do this, they can sell to the manufacturers directly or use the middlemen. In between, a number of processes such as transport and warehousing is carried out. After this, the manufacturers sell back the products to the consumers. Again, they do this directly and indirectly.
Throughout the first part above, there are transactions that happen. A transaction is made up of two parts. There is a buyer and a seller. In a transaction, the intrinsic value of the item is exchanged using a currency such as the dollar or euro.
To do a transaction, you need money. You can get the funds from your salary or other investments. Alternatively, you can get the funds from your bank. When you borrow money from a bank, the money becomes your asset and a liability for the bank. After you finish paying back the money, it becomes its asset and it can lend it to someone else.
In all this, the central bank becomes an important entity. The central bank is given the mandate to print money and ensure financial stability. If the bank prints more money, it leads to inflation. To counter the rising inflation, the bank increases interest rates. This reduces the money flow in the country and ensures financial stability. The bank does this by adjusting the interest rates. For example, the overnight rate is the rate which the banks borrow money from each other. If this rate increases, the interest rates for consumers increase as well.
Another important thing in an economy is productivity growth. The more productive you are, the more money you have. For example, if you earn $20 a hour and work for 40 hours a week, it means that you make $800 a week. If you increase your productivity to 60 hours a week, then you will earn $1200. This will help increase your spending power. Whenever you spend money, it becomes an income for another person.
Therefore, the best way to look at the economy is through the lens of transactions. An improving economy that has a tight labor market means that more people will have more spending power to buy things. As the spending power increases, companies rush to expand to meet the increasing demand. This leads to more demand at the micro level. As this happens, the central bank tends to intervene to prevent the overheating of the economy overheats when everything is going on well. The risk of this is that it could lead to a hard landing when things change. Therefore, the central bank will often tighten with the goal of preventing this to happen.