How Does the U.S. Economy Work?

The United States of America is a union of 50 states in North America. Its official currency is the U.S. dollar. The United States is the world's third largest economy. In 2015, China became the world’s largest economy and the European Union is second. Despite this, the U.S. economy is still powerful.

The United States has a mixed economy. That means it operates as a free market economy in consumer goods and business services, but operates as a command economy in defense, retirement programs, many aspects of medical care, and many 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. That measures everything produced in the United States, regardless of whether it was made by U.S. citizens and companies or foreigners. Don’t confuse it with gross national income, which is everything produced by U.S. citizens and companies, no matter where they are located in the world.

There are three critical measurements of GDP. Nominal GDP is the primary measure. It gives an annualized figure. That means it says how much would be produced for the year if the economy kept going at the same rate. Real GDP does the same but removes the effects of inflation. Economists use it to compare GDP over time. The GDP growth rate uses real GDP to produce the growth compared to last quarter or last year.

There are four components of GDP. Consumer spending is 70 percent of the total. It includes the sub-components of goods and services.

Within goods are durable goods, like automobiles, and nondurable goods, like gasoline. Within services are banking and health care. Services drive 50 percent of the economy while goods drive 20 percent.

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

Business investment is next. It comprises 16 percent of GDP. It includes manufacturing, real estate construction and intellectual properties.

The fourth component is net exports. That's 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. Its biggest export is oil. That's also its biggest import.

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!" You can learn how to predict the next recession by understanding the three forces that affect the economy. They are the laws of supply and demand, the business cycle and inflation. These three forces impact each other.

Supply and Demand

Supply and demand determine 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. In the short run, if demand rises and supply can’t catch up, then prices will rise. High demand for a product will drive up wages of workers who can make that product.

Supply is made up of the four factors of production. They are labor, entrepreneurship, capital goods and natural resources.

Labor is the manpower that turns raw materials into finished products and services. It is measured by the labor force. Natural resources include oil, land and water. Oil prices comprise 70 percent of the cost of gas.

Demand is the consumer's desire to have a good or service. It's only constrained by the consumer’s willingness to pay the price offered.

Business Cycle

The economy is dynamic. Its rise and fall depends on the business cycle. The cycle has four phases. In the expansion phase, the economy grows. If it grows at a healthy rate of 2-3 percent, the economy can remain in the expansion phase for years. But when it enters a phase of irrational exuberance, it creates an asset bubble. That’s the second phase called the peak.

It then enters the contraction. That’s when the GDP growth rate turns negative and the economy enters a recession. Unemployment rises. Find out the causes of a recession.

When the economy contracts for years, it's called a depression. Learn the difference between recession and depression.

At the bottom of the recession is the trough. The economy then enters a new expansion phase. Find out where we are in the current business cycle.

Inflation and Deflation

Inflation is the other great force in the economy. It’s when demand is greater than supply and prices go up. It occurs in the peak phase of the business cycle. 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.

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 financial crises. It occurs during the contraction phase of the business cycle. Find out how to identify and protect yourself from the next economic crisis.

Government Influences

The U.S. government wants to prevent recession and inflation.

High unemployment and skyrocketing prices end politicians’ careers in a democracy. But it’s challenging in a market economy. The government can only influence, not control, the three forces. In a command economy, the government sets prices and supply. Nevertheless, the government has many tools to influence the U.S. economy.

Fiscal policy

Elected officials have many tools in fiscal policy. First, it has the impact of the $4 trillion federal budget. That’s 20 percent of the $19 trillion economy. That amount of money creates growth wherever it is spent. It influences businesses which create jobs.

Most of it goes toward the three largest expenses: Social Security benefits, military spending and Medicare. That’s one reason why the health care industry is such a large part of the economy. Learn more about the rising cost of health care.

All the revenue ultimately comes from your income taxes on your income. It is important for you to know how it is spent.

The president starts the budgetary process each year but only Congress has the authority to spend. For example, President Obama's Economic Stimulus Package was his idea, but it couldn’t go anywhere without Congressional approval.

But spending is limited. When it outpaces revenue, it creates a budget deficit. Each year's deficit gets added to the debt. The U.S. debt is around $20 trillion. That's more than its entire economic output. The statistic that describes this is the debt-to-GDP ratio.

Another government tool is trade policy. It affects the cost of imports and exports by regulating trade agreements with other countries. These agreements, like NAFTA, seek to reduce trade costs and increase U.S. GDP. Between 1993 and 2015, the United States tripled exports to Mexico and Canada thanks to NAFTA.

The United States pursues other bilateral and regional trade agreements. The largest is the Transatlantic Trade and Investment Partnership with the European Union. If it is approved, it will become the largest trade agreement in the world.

Monetary Policy

Congress also created the Federal Reserve System. It is the nation's central bank. It uses monetary policy 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, many experts call the Chair of the Federal Reserve the most powerful person on the planet.

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. That 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. That decreases the money supply.

The Fed has many monetary policy tools. Its most well-known tool is the fed funds rate. The Federal Open Market Committee adjusts that to change interest rates. It also adjusts the money banks have available to lend with open market operations. It adjusts the money supply to manage inflation and the unemployment rate.

These tools control how interest rates affect the economy. Compare the current fed funds rate to the historical fed funds rates.

The Fed has three other functions. It supervises and regulates many of the nation’s banks. It maintains financial market stability and works hard to prevent crises. It provides banking services to other banks, the U.S. government and foreign banks.

Business Influences

There is another major influencer that is not part of the government. That’s the financial markets on Wall Street. 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 subprime mortgages. Demand for the derivatives was so strong it almost forced insurers like American International Group 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. That's why many argue for more regulations on Wall Street.

The commodities market has an unmeasured and unregulated influence on the U.S economy. That's because it's where food, metals and oil are traded. Commodities traders change the price of these things you buy every day.

The foreign exchange markets have a similarly critical impact. Those traders change the value of the U.S. dollar and foreign currencies. That affects the price of imports and exports. Find out the current euro to dollar conversion rate.

How Is the Economy Doing?

These first five indicators tell you how the economy is doing. They are the most closely watched by analysts, Wall Street and the government.

  1. U.S. GDP measures the state of the economy quarterly. The Bureau of Economic Analysis updates it monthly. Here is the current U.S. GDP.
  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 each month. It will also reveal which industries are hiring. It’s updated monthly by the Bureau of Labor Statistics. Here is the current U.S. minimum wage.
  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. They will cut all other costs first in an attempt to delay the pain. The government and the Fed observe it. They try to keep the rate close to the natural rate of unemployment of 4 percent.
  5. 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 then plummet within months. For this reason, the Federal Reserve uses the core inflation rate instead. That excludes energy and food costs. Here is the current inflation rate.

The best way to predict what the economy will do is with the five following leading economic indicators.

  1. The current durable goods orders report tells you how many orders were received by manufacturers. The bulk of this is defense and commercial aircraft since they are so expensive. It also includes automobiles. They also take a long time to build and ship. When orders are high, GDP will increase in the future. A critical measurement within durable goods is capital goods. That's the machinery and equipment businesses need every day. They only order those expensive items when they are sure the economy is getting better.
  2. 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. A rise in manufacturing also benefits other industries. These include transportation, retail and administration.
  3. The stock market often predicts what the economy will do in the next six months. That’s because stock traders spend all day every day researching economic trends and business performance. Here are the Dow’s most recent records.
  4. Building permits give you a nine-month lead in new home construction. Most cities issue the permit two to three months after the buyer signs the new home sale contract.
  5. Interest rates are the most important indicator because that’s how the Fed influences growth. Low interest rates create more liquidity for businesses and consumers. When loans are cheap it spurs demand. On the other hand, rising interest rates shrink the money supply. That makes loans more expensive, weakening demand.

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