Discovering how the economy works: from basic cycles to the decisions that affect us

Understanding how the economy works is essential to understanding the world we live in. Every day, millions of people participate in transactions that fuel an invisible but omnipresent system. This system begins with basic needs and ends with decisions that affect everything from the price of bread at the bakery to the fate of entire nations.

Economics is fundamentally a living system that responds to predictable patterns but also to unexpected variations. On a personal level, it determines how much we earn, what we can buy, and how we plan for our future. On a national level, it shapes prosperity, creates or destroys jobs, and defines the quality of life for millions.

The economy as a living system: a constantly moving network

If we think of the economy as a network of human interactions, we see that every action has consequences. When a person buys a product, they are funding a seller, who in turn pays a manufacturer, who purchases raw materials from a supplier. This chain is not linear but circular, where each link depends on the others.

We all are part of this system. From the farmer who plants to the consumer who shops, passing through transporters, merchants, and advertisers. Companies, governments, and individuals coexist in an ecosystem where supply and demand are the fundamental forces balancing it.

This network is organized into three interconnected sectors that specialize in different functions:

The primary sector: extracting natural resources

The first pillar of any economy is the extraction of natural resources. Farmers harvest food, miners extract metals, loggers gather timber. These raw resources are the essential raw materials that feed the rest of the system. Without this sector, there would be nothing to transform.

The secondary sector: transforming into value

Once raw materials are extracted, the secondary sector takes over. Manufacturers convert basic materials into finished products. A mineral becomes tools, wheat grains turn into bread, wood becomes furniture. This process adds significant value.

The tertiary sector: connecting everything through services

The third sector is composed of essential services: distribution, trade, advertising, transportation, finance. These services play the crucial role of connecting producers with consumers and facilitating all transactions. Without this sector, manufactured products would never reach those who need them.

Some economists expand this classification to include the quaternary sector (information services) and quinary sector (high-level services), but the three-pillar structure remains the most widely accepted model.

Economic cycles: the repeating pattern of booms and busts

The key to understanding how the economy functions lies in recognizing that it operates in cycles. These cycles are predictable in their structure but variable in their duration. An economy does not grow indefinitely; instead, it experiences periods of expansion followed by contractions.

This pattern has deep roots. After each crisis, renewed optimism emerges. Demand reactivates, stock prices rise, companies hire more workers. Then comes the peak, where the economy uses all its productive capacity. Subsequently, expectations change, tensions appear, and contraction begins. Finally, when the lowest point is reached, the cycle prepares to start again.

Four phases that shape the destiny of any economy

There is a consensus among economists about the four stages each economic cycle goes through. Each phase has distinctive characteristics that affect companies, workers, and consumers differently.

The expansion phase: It’s the rebirth after a crisis. Optimism returns to the market, demand increases, businesses expand, jobs are created. Companies invest in new facilities and technology. Stocks rise, unemployment falls, and consumption grows. Everything points toward sustained growth.

The boom phase: At this point, the economy has reached its peak. Factories operate at maximum capacity, almost no labor is available, prices stabilize. However, a paradox arises: although markets maintain some confidence, economists begin to warn of negative signals. Small companies disappear absorbed by larger ones. Growth slows subtly, though few recognize it yet.

The recession phase: Here, negative expectations materialize into reality. Production costs unexpectedly rise, demand falls, profit margins compress. Companies face financial pressure, cut staff, reduce investments. Stock markets decline, unemployment rises, more part-time jobs appear. Consumer spending collapses due to uncertainty.

The depression phase: This is the worst stage. Absolute pessimism prevails even when positive signs exist. Interest rates rise, many companies go bankrupt, the value of money depreciates, stock markets plummet. Unemployment reaches critical levels, investment nearly disappears. It’s only when this phase hits bottom that the expansion cycle begins anew.

Why do cycles vary?: Three different economic dynamics

Not all economic cycles are the same. There are three different types, each with its own time scale and characteristics.

Seasonal cycles are the shortest, lasting only months. A clear example is how retail flourishes during the holiday season or how energy demand varies with seasons. Although brief, their impact can be significant in specific sectors.

Economic fluctuations are medium-term cycles that can last years. They result from imbalances between supply and demand that are not corrected immediately. Overproduction can take years to absorb, creating prolonged periods of stagnation or crisis. These cycles are particularly unpredictable and can trigger severe recessions.

Structural fluctuations are long-term transformations lasting decades. They result from fundamental technological changes or deep social shifts. The Industrial Revolution was one, the digital era is another. During these transitions, some industries disappear, others emerge, and the economy reorganizes itself completely. Although catastrophic in the short term, they generally lead to greater prosperity.

Invisible agents controlling how the economy functions

Hundreds of factors influence economic direction, but some have especially significant power. Understanding these agents is understanding the hidden mechanisms of the system.

Government policies are powerful tools. Through fiscal policy, governments decide how much tax to collect and how to spend revenue. With monetary policy, central banks control the money supply and interest rates. These decisions can stimulate stagnant economies or curb runaway inflation.

Interest rates are the price of credit. When low, borrowing is cheap, encouraging people to buy homes, start businesses, or invest. When high, credit becomes expensive, discouraging spending and investment. In many modern societies, debt is the norm, making interest rates particularly influential.

International trade amplifies or reduces these effects. When countries trade freely, both can prosper if they specialize in what they do best. But it can also cause unemployment in local industries competing with cheaper imports. Trade barriers and agreements deeply shape how global wealth is distributed.

From small to large: microeconomics versus macroeconomics

To fully understand how the economy works, it’s helpful to divide it into two complementary perspectives.

Microeconomics examines the details. It focuses on individuals, households, and specific companies. It studies how prices are determined by supply and demand in individual markets. It analyzes a consumer’s spending decisions, a company’s strategies to maximize profits, how unemployment affects specific workers. It’s the economy of concrete and observable things.

Macroeconomics takes a step back. It looks at the entire economy of countries or the world. It is interested in overall growth, national inflation, aggregate unemployment rates, international trade balances, and exchange rates. Policy makers and central bankers mainly work at this level.

Although they seem separate, they are deeply connected. Aggregate individual decisions generate macro trends, while macroeconomic changes affect individual opportunities.

Understanding the economy is understanding the world

Economics is not an abstract concept but a system that impacts every aspect of our lives. From the price we pay for coffee to national policies affecting our employment, the economy is constantly present. Learning how the economy works empowers us to make better personal decisions, anticipate changes, and understand news about politics and business.

The economic world will continue to evolve, with new technologies, demographic shifts, and global transformations. But the fundamental principles will remain: supply and demand, cycles of expansion and contraction, the interconnectedness of all actors. Those who understand these principles will understand the forces shaping our shared future.