A Crash Course In How The Economy Works

4 minute read

Economies & Economics are not complicated

Though the economy may seem complex at first glance, it functions in a very simple mechanical way. The video below by Ray Dalio is a beautiful summary of how it works and focuses on the fundamentals behind every major economy in the world today.

Before you dive into the video, let’s discuss why it’s important to understand how the economy works. Whether we like it or not, you and I contribute to and benefit from the economy. Our jobs, savings, and investments are all highly impacted by its health.

When you understand how changes and cycles in the economy work and how they will impact you, you are empowered. You become more prepared, less fearful, and less impulsive during economic downturns.

What makes an economy?

An economy is made up of a few simple moving parts and many transactions repeated over and over again. A transaction occurs when you trade money for goods or services.

Everything from buying groceries, to taking Ubers, to dining out is a transaction. These transactions are driven by human nature above all else.

Basic psychological needs and wants drive your decision to spend money. Sometimes it’s a basic need, like food, clothes, or shelter. Other times it’s a want, like Gucci purses or Rolex watches. Don’t worry, if you own any of these things, I won’t judge you (…). In an economy, one person’s spending is another’s income. Always.

Credit

When you buy something, you can either pay for it in cash or credit (or not pay for it at all and end up behind bars). When you pay in cash, you and the seller settle the transaction immediately. If you don’t use cash, you use credit. In that case, the transaction isn’t settled immediately. You become a borrower indebted to the seller. At that precise moment in time, the seller has created credit for you, and you have created debt for yourself.

What is debt?

Debt is when you borrow & spend more money than you currently make.

When you spend more than you make, you essentially borrow from your “future self”. No, I’m not going to go off on a tangent about spirituality… What I mean is when you borrow, you create a “time in future” where your future self needs to spend less than you make in order to pay back your debt from the present.

Borrowing leads to cycles, as there’s no such thing as free money.

Over-spending today means you will need to under-spend in the future. Up today, down tomorrow. What goes up, must come down. Cycles. Got it? Cool.

Markets

We have spice markets, gold markets, meat markets, super markets (get it?) and hundreds of other markets in our economy. Each offers specific goods or services in exchange for cash or credit. All the buyers and sellers transacting for the same set of goods or services makes up a market.

Simply put, a country’s economy is the total value of the transactions in each and every market in that country.

Is credit bad?

Credit is not necessarily bad. It only becomes bad if it finances overconsumption. When it finances productivity, it is good; It helps you grow, increases your spending power, and helps the economy grow.

Borrowing to buy stuff that doesn’t boost your productivity (like TVs, expensive cars, or jewelry) is a bad idea.

Borrowing to acquire stuff that helps you become more effective or productive (like education, power tools, or self-development) is a great way to take maximum advantage of this wonderful thing we call credit.

Lending cycles

Credit helps both parties in a transaction get what they want. Lenders earn interest on the amounts they lend, while borrowers get to buy what they want or need, but can’t afford.

When interest rates are high, it becomes expensive for borrowers to borrow. On the contrary, lower interest rates encourage more borrowing and, therefore, more spending. We’ve covered these concepts in the post about inflation.

Summary

The key takeaways here about the economic machine you should remember are:

  • The total number of transactions across all markets = the economy.
  • Transactions are driven by human nature.
  • Transactions can be based on cash, but more often than not, they are based on credit.
  • Credit helps us spend more than we earn.
  • Used to boost productivity and generate income, credit is great.
  • Used to buy useless stuff you can’t afford, credit will put you in a financial hole.
  • Credit creates short-term cycles in an economy; People get richer today, poorer tomorrow.
  • Use credit wisely — to boost productivity instead of fuel consumerism.
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