How Does the U.S. Economy Work?

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The United States is the world's third-largest economy, behind China and the European Union. The United States has a mixed economy. That means it operates as a free market economy in consumer goods and business services and as a command economy in defense, retirement programs, some aspects of medical care, and other areas. The U.S. Constitution created and now protects America's mixed economy.

Measuring the U.S. Economy

The best way to estimate the size of the U.S. economy is with gross domestic product, or GDP. GDP measures everything produced in the United States, regardless of whether it was made by U.S. citizens and companies or by foreigners.

Gross domestic product is different from gross national income, which is everything produced by U.S. citizens and companies, no matter where they are located in the world.

Components of GDP

There are four components of GDP.

Components of Real GDP (2019)
Component Percentage of U.S. GDP
Consumer spending 70%
Government spending 17%
Business investment 16%
Net exports -5%
TOTAL GDP 100%

Consumer spending comprises approximately 70% of the total GDP. It includes the sub-components of goods and services. Goods can be either durable goods, like automobiles, or nondurable goods (which are immediately consumed and used up), like gasoline. Services consist of things like banking, childcare, and health care. In 2019, services made up 45% of the economy, while goods made up 25%.

Government spending is the second-largest component, driving approximately 18% of GDP. This includes national defense spending, Social Security benefits, and health care. It also includes state and municipal budgets.

Business investment makes up approximately 16% of GDP. It includes elements such as manufacturing, real estate construction, and intellectual properties.

Net exports make up the fourth component. It is the sum of exports, which add to the nation's economy, and imports, which subtract from it. The United States has a trade deficit, which means it imports more than it exports. This is why the U.S. net exports figure has a negative value. 

Exports are goods leaving the country, which the U.S. sells to or in other countries. Imports are goods coming in, which the U.S. buys from other countries.

Measuring GDP

There are three critical measurements of GDP.

  1. Nominal gross domestic product: Nominal GDP is the primary measure. It describes how much would be produced for the year if the economy kept going at a constant rate.
  2. Real gross domestic productReal GDP does the same but removes the effects of inflation. Economists use it to compare GDP over time.
  3. Gross domestic product growth rate: GDP growth rate uses real GDP to calculate growth as compared to the previous quarter or the previous year. This number is often described as a positive or negative percentage.

Some productive activities are not included in GDP, such as the care parents provide for their children and work done by volunteers.

Forces That Impact the U.S. Economy

There are three forces that affect the economy: supply and demand, the business cycle, and inflation. These are measures of how consumers interact with their money and the economy. You can learn how to predict the next recession by understanding how these forces interact with each other and impact consumer behavior.

Supply and Demand

Demand is how much consumers want a good or service. Supply is how much of that good or service is available. The interaction between supply and demand impacts prices, wages, and the amount of product available.

The law of supply and demand says that supply will rise or fall to meet levels of demand over time. If consumers want more of something, businesses will make more of it, until supply meets demand and demand decreases. This process is cyclical.

The Supply and Demand Cycle

  1. Demand for a product increases higher than the supply of that product.
  2. Prices rise.
  3. Higher prices drive up the wages of workers who can make that product.
  4. High demand makes that product more profitable for businesses to produce.
  5. More businesses begin producing it.
  6. As more workers are available to make the same type of product, wages stabilize.
  7. Supply increases to meet demand.
  8. As supply rises, consumers buy all they need.
  9. Demand decreases below the level of supply.
  10. Consumers are willing to pay less, and the product becomes less profitable.
  11. Wages for workers making that product fall.
  12. Businesses begin to make less and focus on the next high-demand product.
  13. Supply decreases to meet demand.

Supply is limited by the four factors of production: labor, entrepreneurship, capital, and natural resources. Demand is limited by the consumer’s willingness to pay the price a product or service costs.

The Business Cycle

The economy is constantly changing, and its rise and fall depend on the business cycle. The cycle has four phases.

  1. Expansion: This is when the economy grows. If it grows at a healthy rate of 2%-3%, the economy can remain in the expansion phase for years.
  2. Peak: The economy is in a phase of irrational growth. This creates an asset bubble and is unsustainable in the long term.
  3. Contraction: The GDP growth rate turns negative. This causes a recession along with rises in unemployment rises. When the economy contracts for years, it's called a depression.
  4. Trough: This is a recession at its lowest point. The economy then enters a new expansion phase and the cycle begins again.

Inflation and Deflation

Inflation can happen either in the short term, due to consumer behavior, or in the long term.

Short-term inflation happens when demand is greater than supply and prices go up. It generally occurs in the peak phase of the business cycle.

Once inflation occurs, people begin to expect ever-higher prices. Consumers buy now before prices go up more in the future. This increases demand and causes higher prices.

Long-term inflation generally happens because of an increase in the money supply over time.

Deflation is the opposite of inflation. It occurs when prices fall, creating crashes in the stock or housing markets, as well as other financial crises. It takes place during the contraction phase of the business cycle.

Government Influences on the Economy

In a mixed economy like the U.S., the government has a few tools that it can use to influence the economy.

Fiscal Policy

Fiscal policy is how the government adjusts its own spending and tax rates to influence or manage economic forces.

Congress, with the influence of the president, sets the federal budget. The highest portion of federal spending goes toward Social Security benefits, military spending, and Medicare. Fiscal policy can also influence entire industries through its priorities, such as whether it focuses on renewable energy or fossil fuels.

Revenue for the federal budget comes from taxes and money that the federal government borrows. But spending is limited. When it outpaces revenue, it creates a budget deficit.

Each year's deficit gets added to the debt. The deficit is funded by the sale of Treasuries securities, which the government is then required to pay back with interest. The U.S. debt is more than its entire economic output.

Trade Policy

Another government tool is trade policy. By regulating trade with other countries, the government affects the cost of imports and exports. The cost of imports impacts the prices of goods and services that are imported and sold in the U.S., while the cost of exports impacts the revenue and wages of U.S. businesses.

Trade agreements, like NAFTA, seek to reduce trade costs and increase the GDP of the United States. Between 1993 and 2015, the United States tripled exports to Mexico and Canada thanks to NAFTA.

Monetary Policy

The Federal Reserve System, the nation's central bank, was created by Congress. Also called the Fed, the Federal Reserve System uses monetary policy to control inflation and stimulate the economy. It is also charged with the smooth functioning of the banking system. There are two types of monetary policy. 

  • Expansionary monetary policy speeds up growth and lowers unemployment. It does that when it lowers interest rates or adds credit to banks to lend, which increases the U.S. money supply.
  • Contractionary monetary policy fights inflation and slows growth. To do this, the Fed raises interest rates or removes credit from banks' balance sheets. This decreases the money supply.

The Fed has three other functions:

  1. It supervises and regulates many of the nation’s banks.
  2. It maintains financial market stability and works to prevent financial crises.
  3. It provides banking services to other banks, the U.S. government, and foreign banks.

The Federal Reserve has several monetary policy tools that it uses to impact the economy.

  • Interest rates: The most well-known tool is the fed funds rate, which the Federal Open Market Committee adjusts to change interest rates.
  • Open market operations: The Fed also adjusts the money banks have available to lend by buying or selling securities to its member banks. Selling securities causes interest rates to rise while buying them causes interest rates to fall.
  • Money supply: Adjusting the money supply allows the Fed to manage inflation and impact the unemployment rate.

Business Influences on the Economy

There is another major influencer that is not part of the government: financial markets on Wall Street. The behavior of traders, investors, and managers in financial markets impact the broader economy.

How Wall Street Impacted the Economy: The Great Recession

In 2008, an implosion in financial markets plunged the economy into the worst recession since the Great Depression. It began with derivatives that were supposed to insure against defaults on subprime mortgages. Demand for the derivatives was so strong it almost forced insurers to default. The threat of default threw Wall Street into a panic, which spread throughout the world and plunged the global economy into a recession.

Trades through foreign exchange markets change the value of the U.S. dollar and foreign currencies, which impacts the price of imports and exports. Hedge funds and hedge fund managers seek higher returns by trading in risky commodities and futures contracts, many of which are minimally regulated. The commodities market is where food, metals, and oil are traded. Commodities traders change the price of these things you buy every day.

Bubbles and collapses in the financial, stock, and housing markets can impact the overall economy, causing recessions and depressions.

Understanding the Current Economy

Once you understand how the U.S. economy works, you can use certain indicators to understand both how the economy is currently doing and what might happen in the near future.

How the Economy Is Doing

These five benchmarks indicate how the economy is doing. They are closely watched by economic analysts, Wall Street, and the government.

  1. U.S. GDP measures the state of the economy every quarter. The Bureau of Economic Analysis updates it monthly.
  2. GDP per capita tells you how much each member of the U.S. population benefits from economic output. It is released once a year.
  3. The current jobs report tells you how many jobs were added (or lost) each month. It will also reveal which industries are hiring. It’s updated monthly by the Bureau of Labor Statistics.
  4. The unemployment rate is a lagging indicator. This means it follows the trends. That’s because employers wait until the economy is strong before hiring. They also wait until a recession is underway before laying off workers. The federal government and the Federal Reserve aim to keep close to an unemployment rate of 4%. The Bureau of Labor Statistics reports unemployment numbers.
  5. Both the U.S. government and the Federal Reserve measure inflation, or how much consumers have to pay for goods and services. They often have slightly different numbers for this benchmark because the federal government uses the consumer price index, while the Federal Reserve uses the core inflation rate.

The consumer price index sometimes gives misleading information. Because the commodities market determines oil, gas, and food prices, these numbers can sometimes plummet and skyrocket within months. The core inflation rate, which the Fed uses instead, excludes energy and food costs to avoid these spikes.

Predicting What the Economy Will Do

Understanding these leading economic indicators can help you predict likely changes in the U.S. economy.

  • The durable goods orders report tells you how many orders were received by manufacturers. When orders are high, GDP will increase in the future.

A critical measurement within durable goods is capital goods, or the machinery and equipment businesses need every day. Business owners only order these expensive items when they are sure the economy is getting better.

  • Building permits indicate whether there will be new home construction in the near future.
  • Manufacturing jobs tell you manufacturers' confidence level. When factory orders rise, companies need more workers right away. That happens long before the goods show up in GDP. Similarly, when manufacturers hire fewer workers, it means a recession could be on its way. Data on manufacturing jobs is available from the Bureau of Labor Statistics.

A rise in manufacturing also benefits other industries, including transportation, retail, and administration.

  • The stock market often predicts what the economy will do in the next six months. That’s because stock traders must research economic trends and business performance in order to make the most profitable trades possible.
  • Interest rates are how the Fed influences growth. Low interest rates create more liquidity for businesses and consumers. When loans are cheap it spurs demand. Rising interest shrink the money supply, making loans more expensive and weakening demand.

Use these benchmarks to make informed judgments about how the economy is currently doing and what might happen next. Understanding these signs of growth and contraction will help you manage your money and protect your financial future.

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