How Economy of Nation Works? (Part-1)

How economy of nation works? You will read a series of articles on this topic. This is part-1 of the forthcoming series of blog posts on economy. Ever since my study on stocks have begun (almost a decade back), I always found a strong correlation between “surrounding economy” and stock market’s performance.

I am sure you must also have realised this interdependency. See, the debt crisis of 2008 in USA, had its impact across the globe.

Hence, it becomes only prudent for us to peep into our economy and see how it works. But the problem is, for people of non-economics background (like me), understanding economy is a tough ask. In fact it will not be an overstatement to say that it is kind of an overwhelming.

So this is my challenge. I have to first decipher economy in my mind, and then put it out in simple words for my readers. Why I am doing this? I believe that, deeper understanding of the surrounding economy, can help people take wiser personal finance decisions. Why? Because surrounding economic conditions eventually effects our day to day money matters.

Imagine how easy it will be for you to time your stock’s buy/sell moves, if you knew when economic expansion or recession is about to come. This has prompted me to write a blog-series on economy. For stock investors, understanding of economy is a great asset. As a blogger, my objective is to share my understanding about economy with my readers.

So let’s begin our journey into the ocean of global and local economy.

Introduction: Economic Cycles

How Economy of Nation Works - Debt Cycles

Our economy works in cycles. What does it mean? At times inflation is up, and at times it is down. The cycles effects everybody, be it government, business, or individuals.

Due to cycles government finds GDP, interest rates, employment going up and down. Similarly, business also struggles to manage its sales, expenditure, profits in times of slower economic growth.

Individuals are also not spared from the wrath of cycles. In moments when economy is growing as expected, salary increments seems to happen with ease. But in times of recession, leave asides salary increments, the threat of job loss looms around.

Why this happens? Why the world’s economy seems to be looming in cycles?

The cause and effects of cycles has been very beautifully explained by Ray Dalio in one of his youtube videos. I will suggest you to watch this video before reading this blog post (How The Economic Machine Works). My blog post can be a perfect after-reading for this video.

This video has explained the flow of economy, and how it works, in simplest of ways. But I think, for non-finance guys, more explanation is required. Hence this blog post…

Who should read this blog?

From very initial days, it was clear to me that understanding economy will not be easy. Why? Because understanding economy means, considering macro, and micro economics in tandem. For non-finance guys, this needs too deep involvement. This makes the topic too overwhelming for novice.

But when I began doing my study, the woking of economy turned out to be far more complicated than my estimation. But it does not bother me. Why? Because my idea was never to “know everything” about the economy. I am sure, it will need a lifetime to know even 50% of what goes into an economy.

My idea is to gather enough pieces of evidence, using which I can explain the working of Indian economy (in general), to my readers.

Today I think I am ready to share my learnings. Though, my idea is far from being perfect, but I think it is still worth reading. I have enjoyed researching it. I am sure you will also like the content.

Who should read it? Everyone. Why? Because after reading it, it will help you to connect the dots. Which dots?

Interest rates, credit, debt, spending, GDP, inflation, recession, fiscal deficit, etc etc.

The list is longer. In fact very long, and that is why connecting all the dots becomes difficult. But all of this together (macroeconomic view), frames our Indian economy.

All these are constituents which ultimately shapes the working of Indian economy as a whole.

So from where will start? Let’s begin with the most basic question…

#1. What it means by economy?

Working of Indian Economy - What is Economy?

Economy is defined by an AREA, where some ACTIVITY happens, caused by the involvement of AGENTS.

AREA: When we are talking about global economy, we are talking about an “area” which includes “activity” and “agents” of all countries within our mother Earth.

When we talk about Indian economy, we have limited our AREA to a country called “India”.

When we talk about US and China’s economy, we have limited our AREA to countries called “USA and China” respectively.

ACTIVITY: Broadly speaking, following four activities can take place in an area:

  • Production of “goods and services“.
  • Distribution of goods and services.
  • Trade of goods and services.
  • Consumption of goods and service.

AGENTS: People who are involved in the above four activities, within an area has been referred as agents. Who are these agents:

  • Government.
  • Business.
  • People (individuals).

To make more meaning out of the word “economy”, sum total of activities done by agents within an area needs to be quantified. How it is done?

We hardly use the word “economy” in isolation. Along with economy, the most used phrase is the “size of economy”.

Market value of all goods and services produced” in an economy builds its size.

How to quantify (give market value) the goods and services produced? Here comes the use of money (currency). The worth (value) of all goods and services are measured in terms of its “monetary value”. It is called as GDP (Gross Domestic Product).

GDP is the market valued of all goods and services produced in a specific financial year. Generally, the economies of all the countries are expressed in USD for comparison.

Example: Top 6 economies of the world in term of their size (GDP), as published by IMF in year 2018

  • WORLD: $79,865,481 Million.
    1. USA: $19,390,600 Million.
    2. China: $12,014,610 Million.
    3. Japan: $4,872,135 Million.
    4. Germany: $3,684,816 Million.
    5. UK: $2,624,529 Million.
    6. India: $2,611,012 Million.

Allow me remind my readers about a very important entity of economy. What is it? Money, without it how we will quantify an economy or even an “economic activity”? Not possible. Let’s see a common example, where money is used to quantify economy.

Example: To define the size of USA’s economy, we have expressed it in USD ($19,390,600 Million). The same thing can be done in Euro, Yen, Pound Sterling, INR etc.

What does it mean? We will need money (a unit) to quantify the overall economy, or even a single economic activity.

Money helps in effecting a transaction. It also helps in summing up of all the economic activities happening in an economy. Let’s see the use of money (in an economy) in a more definitive way.

#1.1 Use of “Money” in an Economy?

We have seen that, all activities happening in an economy can be categorised into production, distribution, trade, and consumption.

Let’s simplify it further to pitch-in the use (utility) of money.

Working of Indian Economy - Transaction Money Credit

To complete a transaction, following things happen at a time:

  • A buyer needs a good (or service).
  • A seller has the needful.
  • The buyer pays for the same in money (or credit) to the seller.
  • In exchange for money, the seller gives the possession good (or renders a service) to the buyer.

In an economy several such transactions happens every minutes, 365 days a year. To effect the transaction, money (or credit) is necessary.

Money not only works as an exchange unit, but it also standardises the unit of measurement of such exchanges.

Unit of money in turn helps to value all the goods and services produced in an economy.

The total value of all goods and services produced in an economy ultimately forms the GDP.

But it is important to understand how people (business, government) spend money. The money will be spent only when the followings are made available at a specific moment in time:

  • There is a Demand (Buyer).
  • There is a Product (Seller).
  • Confluence of buyer and seller in a place (There is a Market).
  • Availability of money with the buyer.

It is essential to understand a bit about the “market“, and how it serves to effect transactions seamlessly.

#1.2 Markets within an economy.

Working of Indian Economy - Sub-markets

Within the big market (total economy), there are various sub-markets. What are these sub-markets?

If India is the big market, following are its sub-markets:

  • NSE/BSE – stock market.
  • Steel Market.
  • Cement Market.
  • Housing Market.
  • Auto Market.
  • Fuel market.
  • Food Market.
  • Clothing Market.
  • Furniture Market etc.

In all these markets, transaction keep happening. You can imagine in a big country like India how many transactions might be happening in a matter of few minutes.

All these transactions (between buyer and seller) shapes the GDP of India.

There is an important thing to figure our here. What triggers these transactions which ultimately shapes our economy? Spending by the buyer.

#1.3 Spending:

Nothing is more important in an economy than “spending”. Unless one actually spends his/her money, economy will not shape up.

  • Only production is not enough.
  • Only demand (for products) is not enough.
  • Only availability of market is not enough.
  • Only availability of money is not enough.

This is one reason why, in our modern economic system, so much emphasis is made on “making the consumers spend their money”.

You must have heard the terms like “economic stimulus”. This is nothing but stimulating the buyers (government, business, individuals) to start spending money. Unless money is spend, GDP cannot be build.

Read more about how GDP is measured in India.

Conclusion

This is all about the first few words on economy. Keywords that must be understood here before proceeding to Part-2 of the series are these:

  • What is Economy?
  • Why investors shall understand economy?
  • Economy works in cycles.
  • Economy will not work without money.
  • Concept of markets within an economy.

With this basic know-how, now we are reading to know more about the following two (2) CYCLES of economy.

  • Short Term Debt Cycle.
  • Long Term Debt Cycle.

Our next post will be on “short term debt cycle“…

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