Understanding, how the economic machine works?

Just like any other machine, Economics follows dynamic alignment of components and characteristics. These components act different at 'Macro' and 'Micro' level. In this, I made it simple so people from any background can get a very good understanding of principles of economics. The basic building block for economic engine is 'Transaction'.The strong forces that drive the economy are Productivity growth, short term debt cycle and long term debt cycle, together all helps us understanding the GDP of economy.

Transaction: The exchange of credit/cash between and sellers and consumers in return to the service/product/financial services makes it a transaction. All the transactions happen across different markets like real estate,fruit market, stock market etc., in which banks,businesses, consumers, sellers,governments become a part to aid these transactions building economy.

A Government is which collects taxes and spends money and a federal bank controls the amount of money and credit in the economy. Federal bank controls the interest rates and prints money.

Credit: The financial principal what borrower takes from lender in assurance to repay with interest. As soon as credit transaction happens,a debt is created which is asset to lender and liability to borrower. When one spends from the credit that's someone else's income and vice versa, this is what drives the economy. Credit indirectly sets the economy in motion. The total amount of credit in US is $50 Trillion USD (cash-$3 Trillion USD) ,India-$513 Billion USD.

Credit is bad when its consumption is more comparative to income,that's over-consumption and can't be paid back and is good when its used effectively and paid back.

Economic growth and cycles: When a borrower's income increases he spends more . Remember one's spending is somebody else's income, hence somebody's income increases and this creates economic cycles. When borrowers income to debt ratio increases , his creditworthiness increases making him borrow more and spend more increasing the economic growth. Simply put, in order to buy something you can't afford you need to spend more than you make borrowing from your future self implying that in future you have spend less than you earn to repay it back and all this creates short term debt cycles.The avg debt cycle time in US from history is around 8 years.

-Over long period of cycles, more debt is created than income creating 'long term debt cycle'

Productivity growth: In order for a seller to earn some credit/cash, he has to sell something. in other words in order to get more we have to produce more. Considering at micro level if a person is hard working/innovative produces more and spends more which increases the productivity growth of an economy but in long run so it doesn't influence economy much where as credit increases the productivity growth in short run. Debt is big player in economic swings because it lets to spend more than we produce(when it is borrowed) and lets to consume less than we produce when we pay it back.

*Consider an economy without debt, the only way to increase growth is to increase income which requires to increase productivity/work hard more.

Inflation & Recession: When the amount of spending/income increases than the production the price increases, this is called 'Inflation'. federal bank controls inflation by increasing the interest rates making less people to borrow/making borrowing more expensive. This decreases people's spending, decreasing other people's income and hence the economic activity decreases decreasing the prices, this is 'Recession'. When there is Recession and no problem of Inflation fed bank lowers interest rates to pick up the economic activity. In other words when there is easy credit available it creates economic expansion and if the credit is unavailable it creates Recession.

Economic Bubble: When the economy is growing which means, peoples incomes grow making them to spend/borrow more increasing the asset values with stock market roaring making it a bubble to burst.

Debt burden: the ratio of debt-income is called debt burden. Initially with less debt burden, people/country borrows more and spends more increasing the asset/service value, but over period of time the being the debt burden increases increasing re-payments and spending decreases and hence asset values drop after the 'Long Term Debt Peak'. This was what happened in US during 2009 recession.

-If the debt is increasing at higher rate than incomes, it can never reduce debt burden.

Deleveraging: Economy becomes deleveraging after the debt peaks cutting the people's income, forcing to spend less, sell their assets, banks gets squeezed, stock markets crash and cycles go falling. This drops the collateral values making them less credit worthy. less spending- less income- less wealth -less credit -less borrowing. This appears similar to Recession but the primary difference being interest rates can't be lowered to any lower(interest rates reach 0%) to put back economy in motion. In 2008 interest rates dropped down to 0%.

-Debt burden becomes too high that individual/institution can't repay and their collateral value drops . If the lender don't have enough financial reserves to sustain this situation they file for bankruptcy and the economic motion stalls. The solution for deleveraging economy is to decrease the debt burden. People,businesses cut their spending,debts are reduced by default/re-structuring, wealth is redistributed from have's to have not', fed bank prints money.

Deflation: Usually spending is cut first. Austerity happens and borrowers stop taking new loans and start repaying old debts the debt burden actually doesn't decrease since spending is also cut much more than the debt repaid. This makes governments to tighten belts and reducing salaries, companies to layoff people.

Depression:Second, when the borrowers can't repay, the banks people who saved/lent in/to banks start rushing to banks to get back their money/assets squeezing the banks. This is called 'Depression' This makes borrowers to realize, what all is considered their wealth is actually not.

Debt restructuring: happens when lender gets paid back less/lower interest rate/longer term than expected. They would have something instead of nothing calling settlement.

All this causes Govt to collect less taxes means less income on other hand increasing their expenditure for unemployment. Government budget explodes. Govt needs to increase taxes from rich which facilitates redistribution of wealth in economy. Inevitably fed banks prints money to make govts buy financial assets. In 2009 US fed bank printed around $2 Trillion USD. Fed bank can only buy financial assets on other hand Central govt can buy good /services and put money in hands of people. Fed bank and govt should work together to handle the situation , as such bank prints money and buy govt bonds to help them fight situation. If too much money is printed, it causes high inflation and its a bad strategic planning and it should be the last option

GDP(Gross domestic Product): US produces around $21 Trillion USD worth of goods every year while China produces $14 Trillion USD. The US department of Commerce measures everything it is consumed since everything that is consumed has to be produced . Consumer spending + Business investment + Govt spending(C+I+G)= total consumption with some exceptions, as all of that is consumed might be from overseas and all of that is produced might be exported. Also, there might be something produced in the past or consumed in the present, They correct it by Inflation rate, Time Value Money . All this summed up together gives GDP. GDP can be increased either increasing the production or by increasing more number of people to work force/increasing productivity. It is not good measure to analyse economy.

Purchasing Manager Index: In the US, one of the most followed economic indicators is the Institute of Supply Management’s Purchasing Manager’s Index or PMI for short. The ISM’s PMI is a survey sent to businesses that span across all North American Industry Classification System (NAICS) categories to collect information on production levels, new orders, inventories, deliveries, backlog, and employment. The information collected can be used to forecast the overall business confidence within the economy and helps determine if it shows an expansionary or contractory outlook.

One of the reasons why PMI is one of the most followed economic indicators is because of its strong correlation with GDP, while being one of the first economic indicators to be released monthly. The component GDP that the PMI most closely relates to is the Investment component.

Consumer Purchasing Index (CPI): While not directly related to the GDP, inflation is a key indicator for financial analysts because of its significant effect on company and asset performance. Inflation erodes the nominal value of an asset, which leads to a higher discount rate. Based on the fundamental principle of the Time Value of Money (TVM), it means that future cash flows are worth less in present terms.

List of Economic Indicators: These indicators help to evaluate the performance of macro economy.

Leading Indicators

• Stock Market Performance

• Retail Sales Figures

• Building Permits and Housing Starts

• Level of Manufacturing Activity

• Inventory Balances

Lagging Indicators

• GDP Growth

• Income and Wage Growth/Decline

• Unemployment Rate

• CPI (Inflation)

• Interest Rates (risking/falling)

• Corporate Profits

source: Corporate Finance Institute

source: investopedia

Ref: Principles by Ray Dalio