The Economic System

When we invest money into the economy, we are investing in companies that create and distribute goods and services, or we can be investing directly in the raw materials known as commodities like gold, corn, or oil and gas. So, it’s a good idea to have a working knowledge of economics.

Economics is the study of the economy and how countries produce, distribute, and consume goods and services. You may have heard about macroeconomics and microeconomics, and these terms are good to know. Macroeconomics looks at the performance, structure and behavior of an economy, while microeconomics focuses on how individuals and organizations distribute resources like money, oil, precious metals, and farm products. 

Three things that impact the economy are the Gross Domestic Product, Productivity, and the Economic Cycle :

Gross Domestic Product or GDP is the value of goods and services produced in the country, and the growth rate of GDP is the most popular indicator of the nation’s overall economic health. GDP allows governments and businesses to determine if changes need to be made, in order to keep the economy growing at a good pace.

Although GDP does not include everything we do as humans in society, it is used globally to help identify possible risks to the economy that could affect future growth. Risks to GDP include:

  • Climate Change & Natural Disasters
  • Unemployment
  • Government failure that occurs more often in smaller developing countries
  • Supply Chain Disruptions where businesses are unable to manufacture due to lack of access to parts
  • Financial Crises
  • Social Instability

However, GDP does not measure:

  • The health, well-being, and standards of living
  • The productivity of individuals who work in their home like caretakers or volunteer hours in the community
  • environmental damage
  • wear and tear on products like equipment used to manufacture a products

In addition to GDP, Productivity also affects the economy. Productivity basically measures how long it would take one person to make or manufacture one item or provide a service. Let’s look at two productivity measures:

First we can measure productivity by the number of items that are produced each hour. Say a factory produces 250,000 items and uses 25,000 hours worth of labor to produce the items. Productivity would be 10 items per hour. This is calculated by dividing the number of items produced (250,000) by the number of labor hours to produce the items (25,000). To increase productivity by items per hour we need to increase how many items are produced each hour.

We can also measure productivity by sales. Using the same factory as an example, let’s say the  250,000 items translates into $5 million dollars in sales. We divide the $5 million by 25,000 labor hours in order to get our productivity number of $200 in sales for each hour of labor. To increase productivity by sales we need to increase how much we sell the items for or reduce the number of labor hours to make each item. 

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A country’s ability to improve its standard of living depends almost entirely on its ability to produce more goods and services for a given number of hours of work. When productivity fails to grow significantly, it limits potential gains in wages, corporate profits, and living standards.

Lastly, let’s look at the four stages of the Economic CycleFactors that are used to indicate the stages in the economic cycle include gross domestic product, consumer spending, interest rates, and inflation. 

  • The first stage is expansion when the economy experiences relatively rapid growth, interest rates tend to be low, production increases, and inflationary pressures build. Inflation is when prices go up and your money doesn’t buy as much as it used to. 
  • The second stage is the peak, and this is when the economy reaches its maximum growth rate. Peak growth typically creates some imbalances like prolonged inflation.
  • The third stage is contraction or a correction in the economy when growth slows, employment falls, and prices stagnate. Two important things to watch for during this stage are recessions and depressions. 
    • A recession is a period of declining economic performance across an entire economy that lasts for several months. Recessions are visible declines in industrial production, employment, real income, and wholesale-retail trade. 
    • A depression is a more severe version of a recession. Ultimately, depressions are measured given how severe they are and how long they last. 
  • The fourth stage is the trough; this is when the economy hits a low point and the economy begins to grow and recover.

Understanding the economic cycle can help investors and businesses know when to make investments for example buying when prices are low and selling when prices are higher or at the highest point. The economic cycle has a direct impact on everything from stocks and bonds, as well as profits and corporate earnings.

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