How Does the U.S. Economy Work?

Have you ever said to yourself - "Exactly how does the U.S. economy work?" During a recession, you might think "Not too well!" Learn the causes of recession by understanding gross domestic product and the laws of supply and demand. Know how the federal government uses fiscal and trade policy. Realize how the Federal Reserve fights inflation while spurring growth with monetary policy. See how financial markets on Wall Street influence Main Street and your neighborhood.


What is retailing
Consumer spending drives most of GDP. Photo: Peathegee Inc

Everything the U.S. economy produces is measured by GDP. When the GDP growth rate turns negative, the economy enters a recession.

That has happened throughout the history of U.S. recessions. When the economy contracts for years, it's called a depression. Learn the difference between recession and depression.

The most important part of the economy is consumer spending.The other three components are business and government spending, and net exports. 

The U.S. economy is no longer the world's largest. That's because current U.S. GDP statistics are not keeping up with China and the European Union. Despite this, the U.S. economy is still very powerful.

Supply and Demand

Oil drilling
Oil drilling workers on rig in Houston, Texas. Photo: William H. Edwards/Getty Images

Supply and demand are the forces that drive the U.S. economy. Supply includes labor, represented by employment, and natural resources, such as oil, land, and water. Oil prices drive  70 percent of the cost of gas.

Demand, or personal consumption, drives almost 70 percent of the economy. A lot of this occurs during the holiday shopping season, which starts on Black Friday.

The recession increased unemployment. Many people became discouraged of ever finding a job, and dropped out of the labor force. As a result,  one-third of Americans are poor or near poor. That's one reason the U.S. economy has slowed. But income inequality wasn't caused by the recession. It began worsening through the 2000s.

Inflation and Deflation

fruit at a grocery store
Inflation and deflation show up each week at the grocery store. Credit: The Image Bank/Getty Images

Inflation happens when demand is greater than supply, and prices go up. For more, see How Does Inflation Impact My Life?

Inflation is very difficult to stamp out. Once it occurs, people begin to expect ever higher prices. That's because they will buy now before prices go up more in the future. That increases demand even more. Another cause of inflation is  an increase in the money supply.

The U.S. government measures inflation with the Consumer Price Index. But it sometimes gives misleading information. That's because the commodities market determines oil, gas, and food prices. They can skyrocket and plummet within months. Therefore, the Federal Reserve uses the core inflation rate instead. That excludes energy and food costs. Find out the ​current inflation rate

If inflation occurs in assets, such as housing or stocks, it's called an asset bubble.

Deflation is the opposite. It occurs when prices fall. That also happens to assets, such as housing prices and stock portfolios. That creates stock crashes and economic crises. More

Fiscal Policy

government spending
The Federal government spends more than it takes in. Photo: Brand X Pictures/Getty Images

Fiscal policy is the $4 trillion federal budget. All the revenue ultimately comes from taxes on your income, so it is important for you to know how it is spent. Fiscal policy can stimulate, guide or depress the economy, but only business can create economic growth.

The president starts the budgetary process each year, but only Congress has the government spending authority. For example, ​ President Obama's Economic Stimulus Package was his idea, but Congress approved it. 

Spending typically outpaces revenue, creating a budget deficit. Each year it is added to the national debt.

​​One large contributor to the deficit and debt are the Bush tax rebates. They follow ​the theory of supply-side economics. It says that lower taxes will eventually spur the economy enough to replace the loss in taxes. That hasn't happened. But tax rebates are very popular because people hate paying them. That's why many have proposed a flat tax or a ​fair tax

Monetary Policy

Janet Yellen image
Federal Reserve Board Chairwoman Janet Yellen speaks during a Financial Stability Oversight Council (FSOC) meeting May 7, 2014 at the Treasury Department in Washington, DC. Photo by Alex Wong/Getty Images

Monetary policy is controlled by the Federal Reserve. That banking system is guided by the Fed Chair, Janet Yellen. The Federal Reserve tools include the fed funds rate, the money supply and the use of credit. These tools control how interest rates affect the economy. Compare the current fed funds rate to  historical fed funds rates

The primary objective of monetary policy is to control inflation. Its secondary objective is to stimulate the economy. It is also charged with the smooth functioning of the banking system. For this reason, the Federal Reserve Chair is often called the most powerful person on the planet. 

In 2009, Ben Bernanke Was Named Time's Man of the Year. That's because he took aggressive steps to address the 2007 banking meltdown and the 2008 financial crisis. Nevertheless, many critics argue that the United States should return to the gold standard.

Trade Policy

The Doha multilateral trade agreement would have lowered grocery prices, if successful. Photo: Thoas Kokta/Getty Images

Trade policy affects the cost of imports and exports by regulating trade agreements with other countries. 

Trade agreements, like NAFTA, seek to reduce trade costs and increase each country's GDP.  The World Trade Organization attempted an ambitious world-wide trade agreement in the Doha round of trade talks. That didn't work, since the EU and United States didn't want to end agricultural subsidies. 

Instead, the United States pursued bilateral and regional trade agreements. These include the Trans-Pacific Partnership and the  Transatlantic Trade and Investment Partnership. If they were approved, they would be the largest trade agreements in the world.

Exchange rates affect trade by changing the value of the U.S. dollar. That's because the dollar is the world's global currency. That means most international trade contracts are done in dollars.  When the Dollar is strong, it allows the prices of oil and other commodities to fall. That can create deflation.

Financial Markets

Put Options Trader
Traders in the Standard & Poor's 500 stock index options pit at the Chicago Board Options Exchange (CBOE) fill orders shortly before the close of trading on October 28, 2015 in Chicago, Illinois. Photo by Scott Olson/Getty Images

An implosion in the financial markets threw the economy into the worst recession since the Great Depression. How did this happen? It began with derivatives that were supposed to insure against defaults on sub-prime mortgages. Demand for the derivatives was so strong, it nearly forced insurers like AIG to default. That threw Wall Street into a panic which spread throughout the world. For more, see  How Did Derivatives Create the Credit Crisis?

The building blocks are stocks and stock investing. They are riskier than bonds. The safest are  Treasury bonds. The riskiest are junk bonds. You can invest in either with mutual funds.

Many wealthy investors let hedge funds do the investing for them. Others seek higher returns by trading in risky commodities and futures contracts and credit default swaps. That's why many argue for more regulations on Wall Street.