US Economy

Understanding how the US economy works is a daunting task. That’s because there are a lot of factors that can have an effect on the economy. Some of these factors have an immediate effect and others take months or years to have an effect.

Of course this is further complicated by the fact that economics is as much an art as it is a science. Economists don’t always agree as to what causes certain things and how much of an influence a particular factor has.

Here I will try to give some general knowledge about how the economy works and what some of the important influences are. The information here by no means covers all the knowledge of economics but is designed to give more of a bird’s eye view for beginners.

Google defines an economy as “a system of production and distribution and consumption.” Economics, is the study of how products are produced, distributed and consumed in a particular area.

Every country’s economy is a little different and can even be different between regions. The economy of China is very different from that of Germany or the United States. Within the United States, the economy of California is somewhat different from that of Nevada or New Jersey. Here, I will mainly discuss the US economy.

Supply and Demand

Therefore the public determines the price of items through a system of supply and demand. To understand supply and demand we can look at a simple example.

If someone is willing to pay $5 for you to build a chair, you may not be able or willing to do this. Maybe someone out there is but not you. But if someone offered you $1 million to build that same chair, you would probably be willing to build as many as they wanted. That’s supply. The more people are willing to pay for an item, the more supply there it.

Demand works the same way. If someone offers to sell you a chair for $1 million, you probably aren’t going to want too many chairs. On the other hand, if they would sell it to you for $1, you may decide you could use a few for your house and you would buy them.

So sales happen at the price point at which the person willing to buy is the same as the person willing to sell.

In order to study an economy, it is necessary to measure certain aspects of that economy so you can compare it to other economies.

Economists came up with Gross Domestic Product (GDP) as a way to measure an economy. Gross Domestic Product is simply the total amount of all products and services made within the borders of a single country in one year.

Simply, the country with the largest GDP has the largest economy. According to the International Monetary Fund, in 2008, the European Union had a GDP of over $18 trillion, the US economy was over $14 trillion, Japan was almost $5 trillion and China was over $4 trillion.

To many economists, the actual GDP is not as important as how fast the economy is growing. This is measured by simply looking at this year’s GDP, subtracting last year’s GDP and dividing by last year’s GDP. So if the U.S. had a GDP of $14 trillion last year, and it has a $15 trillion GDP this year, the growth rate is 7.1% ($15 trillion minus $14 trillion is $1 trillion, $1 trillion divided by $14 trillion is 7.1%)

We want the US economy to grow every year because when the economy grows, most of the people in that country grow wealthier. But too much growth leads to inflation which can be destructive.

If the economy shrinks in one year, or grows too slowly, we can have unemployment and recession which can destroy the wealth of many of the people in a country.

Ideally we would like to see slow growth, with low unemployment and low inflation. But that’s not always easy to maintain.

Factors that Affect the Economy

Although these swings have been abnormally large in the past 10 years, the swings themselves are simply a part of the normal ups and downs of the economic cycle.

Another factor that affects the US economy is unemployment. If firms begin laying people off, there are less people who can spend money and so the demand for products goes down. However, due to the reluctance of firms to lay people off, unemployment tends to happen at the end of an economic downturn rather than before. Currency exchange rates can also have an effect on the economy. If the U.S. Dollar gets weaker against other currencies, it becomes cheaper for foreigners to buy U.S. goods and services. This means more spending on our good and it usually means that the economy will grow.

Too much growth can lead to inflation. Inflation basically means that the cost of goods go up. Inflation lowers people’s living standards because they can’t buy as much for the same amount of money.

The national savings rate and personal debt levels can also be an important factor. If people save more, it means they are spending less on goods and services and demand goes down. This can slow the economy. If personal debt levels go down, it can also mean less spending. The opposite is also true. If savings rates go down and debt levels go up, it can mean faster growth for the economy.

The next major influence on the US economy is the country’s banking system. In the US we call the controlling body the Fed. The Fed was established to help promote slow, steady growth in GDP with low inflation and low unemployment. They have a few tools at their disposal to do this but I will only go over the main one.

If the Fed wants the economy to grow, it basically puts more money into the economy by cutting interest rates (There are other ways to do this but this is the main one). By cutting interest rates, more companies and people borrow money. They use that money to create new projects and products. If the Fed wants to slow the growth of the economy (in order to limit inflation), it will raise interest rates. When interest rates go up, people tend to borrow less money to start projects and the economy tends to slow down.

Finally, decisions made by the government can have a large effect on the US economy. If the government decides to raise taxes but doesn’t raise the amount it spends, then there are less dollars in the economy to buy things. If they cut taxes without cutting spending, there is more money to spend and the economy tends to grow. If they raise spending without changing taxes, there is more money in the economy and the economy grows. If they cut spending without changing taxes, the economy suffers.

The Relationship Between These Factors

All of these things (and many others) are working at the same time. And predicting what the economy will do in the future is almost impossible.

For example, when the monetary crisis hit the government dumped a ton of money into the system. Interest rates were cut to promote lending and government spending went up to stimulate growth. But at the same time, people cut their personal debt and began saving more. This dampened the effects of the government spending.

We don't yet know what the outcome of all this will be on the US economy in 5, 10 or 20 years. Only time will tell.

The point is that there is no direct relationship to any of this. If government spending increases, it doesn’t guarantee the economy will improve. And if taxes go up, it doesn’t guarantee that the economic growth will slow. There are a million other factors at work that can change the whole direction.

The good news is that the US economy is very resilient. Except for major shocks to the system (like the financial crisis in 2008) the economy is pretty good at absorbing both good news and bad.

For example, back in the late 1990’s and early 2000’s, many Americans were extremely worried that all the US jobs were going overseas to China and India. It was true that companies were beginning to outsource jobs to these countries in alarming numbers. Since then, the U.S. dollar has dropped in value against these currencies. At the same time, the standard of living in China and India has risen. These two factors have made it much less attractive for U.S. companies to outsource jobs to these countries. And there is plenty of evidence to suggest that this trend of jobs moving overseas has slowed dramatically.

The point is that the headlines about major problems with the US economy are usually simply media scare tactics to drive ratings. Although there are occasions when things get very bad, the economy has always recovered. And I would bet it always will.