Attempting to understand just how the U.S. economy works is a fairly complex thing.
But when you boil down to the basics, the understanding of the U.S. economy is actually pretty clear.
The key to answering the question of how the U.S. economy works has to be drilled down into the factors that make up economic movement.
While various policies have a big role in how the economy works, there are other factors such as spending and American financial markets.
In this article, we will look at seven factors of how the U.S. economy works.
The 7 Factors of How the U.S. Economy Works
1. Supply and Demand
Perhaps the biggest forces that drive the U.S. economy are supply and demand.
It includes more than just products, such as labor and natural resources. For example, oil, land and water are all natural resources. The price of oil has a significant impact on the price of a gallon of gas for your car.
Demand is the biggest driver of the economy — about 70% — as product prices are directly correlated to the demand for that product. When prices of a product go up, in most situations, the demand goes down.
If the latest iPhone was only $50, consumers would likely buy the product in larger quantities.
However, if the same iPhone was $5,000, the demand would be much less because many would be priced out of being able to purchase one.
The supply side of the equation works in a similar fashion, only geared toward impacting suppliers.
If that iPhone was priced at $50 retail, it’s likely the manufacturer would make less because the profit margin would be low. However, at $5,000, there would be more iPhones manufactured because the manufacturer would make an enormous profit.
Because of its impact on the economy, supply and demand is one of the seven factors of how the U.S. economy works.
2. Gross Domestic Product
The gross domestic product of a country is simply the value of any goods and services produced by that country in a year.
The higher the GDP, the more value attached to those goods and services.
In the United States, the GDP grew 2.1% in each of the last two quarters, suggesting steady but not breakout growth.
GDP growth or contraction is perhaps the most widely used indicator for the overall health of the economy.
The importance here is when the GDP is expanding at a rapid pace, it means the country is growing economically. This can lead to job, business and investment growth. A slower rate of growth, or even contraction, means the opposite will happen.
Because it is the most common track of economic health, GDP is one of the seven factors of how the U.S. economy works.
3. Rate of Inflation and Deflation
A big impact of supply and demand is inflation.
When demand is greater than supply, you have a period of inflation. The challenge is reversing course on inflation. However, when there is a state of economic inflation, higher prices usually follow. This means people are more likely going to continue buying products because of the expectation of those higher prices.
Inflation can also be caused by a jump in the supply of money in the market.
You can easily tell the impact inflation has on you personally by looking at the rate of price increases compared to the rate your income changes.
The inflation rate is determined by the Consumer Price Index, which measures the average change in prices paid for goods and services. The CPI has risen 2.3% in the last 12 months. But because the CPI includes speculative things like commodities and food prices, the Federal Reserve uses a core inflation rate to measure it. Core inflation has risen 2.3% in each of the last three months up to December 2019.
Conversely, when product prices fall, it can create deflation. Deflation can also occur with housing prices and stocks, which has a worse effect on the economy than inflation.
Because the rate of inflation and deflation can directly impact economic performance, it is one of the seven factors of how the U.S. economy works.
4. Trade Policy
The textbook definition of trade policy is the goals, rules and regulations that relate to how countries trade with each other.
But it’s a little more in-depth than that. You have an import-export policy, tariffs, quotas and many other nuances that make up trade policy.
Trade has been in the headlines quite a bit because of tensions between the U.S. and China. The crux of the issue was American officials were looking to combat the growing trade deficit between the two countries.
So, putting tariffs on Chinese imports and asking Beijing to buy more American-made products helps erase that deficit — $349 billion in 2019.
Rather than have a trade war, most nations attempt to negotiate individual country or regional trade agreements that stipulate things like how much product each country should buy from the other.
Trade is impacted by exchange rates. Because the dollar is the transactional currency used in most trade agreements, if the dollar is strong, commodity prices fall. That can create deflation, making it one of the seven factors of how the U.S. economy works.
5. Federal Budget
Remember, individuals aren’t the only ones who spend money on goods and services in the U.S.
A big driver of spending with businesses is the federal government. This is dictated by the federal budget. Each year, the president lays out and presents a budget, but it is Congress that has the authority to spend money.
The budget includes both revenue coming in and expenses going out. Revenue coming in is generated by personal and corporate taxes paid each year.
This goes back to supply and demand. It is common to suggest tax cuts for individuals and businesses, putting more money in your pocket. The intent is that you use that money to either grow your business or spend more discretionary income on goods and services.
More often than not, the amount of money the government spends is more than the money it takes in. This creates a budget deficit. For fiscal year 2020, the Congressional Budget Office projects a federal government budget deficit of around $1 trillion.
That deficit didn’t happen in one year. In fact, from 2012 to 2013, the deficit dropped to $719 billion from $1.1 trillion the year before. In 2019, the projected deficit is $960 billion. So, it does fluctuate depending on how much the government spends compared to what it brings in.
Because it dictates federal spending, the federal budget is one of the seven factors of how the U.S. economy works.
6. Fed Rates
The federal government attempts to control inflation by enacting different monetary policies.
One of the biggest parts of monetary policy is interest rates controlled by the Federal Reserve.
Currently, the Fed left fed funds rates unchanged — between 1.5% and 1.75% — signaling a wait-and-see approach. In 2019, the Fed cut rates three times in response to a weakening global economy while inflation was below 2%.
Other outside factors can contribute to why the Federal Reserve would see an economic slowdown.
When the economy slows down, the Fed has a tendency to cut rates as a way to make it more enticing to borrow money or invest. Businesses are encouraged to add jobs or invest more, and individuals may spend more or even borrow more money. Those things can spur economic growth.
The downside is when the rate is too low, economic expansion can grow too quickly, causing inflation. This is when the Fed will raise rates to force you to not spend as freely, thus slowing down the rapid growth.
The fed rates also determine the interest rates of U.S. public debt. Just like with any personal loan, the lower the interest rate, the less the payment on the debt is. Lower interest rates mean lower debt service. The debt is basically an accumulation of budget deficits. That debt is currently around $23 trillion.
The U.S. has a very high debt-to-GDP ratio, meaning it could be difficult for the government to pay back that debt. Think of it like a car loan: One of the factors banks look at in determining loan qualification is your debt-to-income ratio — how much you owe compared to how much you make. A higher ratio makes it difficult for the bank to think you can pay off the loan.
Because of their ability to spur or pull back growth, fed fund rates are one of the seven factors of how the U.S. economy works.
7. The Stock Market
A common misnomer is that the stock market is basically the economy. This is incorrect.
Instead, the stock market can be used as a gauge on how the economy is doing. The better the economic health, the more investors want to buy. The worse the economy, the greater the market pullback.
When the market tumbles, it means investors are not as confident in the state of the economy. Stock prices go down and those businesses have less capital to work with. This can cause a halt to business growth and even job cuts.
The above-mentioned interest rates set by the Federal Reserve can have an impact on the markets. Higher rates mean money is more expensive to borrow, causing companies to not be able to borrow as much to pay for goods and services. This can have an adverse impact on stock prices.
Because it is a strong gauge in economic health, the stock market is one of the seven factors in how the U.S. economy works.
So while the U.S. economy can seem like a complex operation, you can look at these factors to help determine just how it all works.
From inflation to fed rates, there is quite a bit that goes into making an economy grow. Just one factor does not determine the direction, but it can have a strong impact.
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