The functioning of the economy: Keys to understanding the system around us

Have you ever wondered why prices go up or down, or how jobs are created? The functioning of the economy is the invisible mechanism that affects every decision we make, from what we buy at the supermarket to how much it costs to get a loan. Although it may seem like a complex and often confusing concept, understanding how the economy works is essential for all of us, as it directly determines our quality of life, employment opportunities, and the prosperity of our societies.

Economics is much more than numbers and charts: it is the complex fabric that underpins modern society. From the price of a coffee to a country’s fiscal policy, everything is interconnected within this dynamic and constantly evolving system.

What is economics and how does it work in practice?

Economics is an integrated system that encompasses the production, exchange, distribution, and consumption of goods and services. It is the force that keeps our societies moving, including businesses, households, budgets, and all transactions that generate value.

To understand how these dynamics work, let’s imagine a typical chain of events: a manufacturing company obtains raw materials from a supplier, processes them to create a product, then sells it to a distributor who adds value through packaging and distribution, and finally it reaches the end consumer. Each step in this chain influences the others. If demand for raw materials increases, prices go up; if consumers reject the final product, the entire chain is affected. This is the core of economic functioning: the constant relationship between supply and demand.

Key players in economic functioning

We all participate in the economy. Consumers who spend money, workers who produce, companies that sell, and governments that regulate are essential cogs in the system. Each plays a specific role in maintaining the operation of the economic machine.

These actors are traditionally organized into three main sectors:

The primary sector extracts natural resources from the environment: mining, agriculture, forestry. It generates the raw materials that feed the rest of the economic system.

The secondary sector transforms these raw materials into finished products through manufacturing and processing. Some of these products go directly to consumers; others become components for more complex industries.

The tertiary sector provides essential services such as distribution, advertising, consulting, and finance. Although some scholars subdivide this sector into quaternary and quinary categories for greater precision, the three-sector model remains the general consensus.

The engine of economic functioning: Supply and demand

The fundamental principle explaining how any economy functions is the relationship between supply and demand. When many people want a product (high demand) but few units are available (low supply), prices rise. Conversely, when there is abundance but low demand, prices fall. This automatic mechanism balances markets and guides resource allocation throughout the economy.

Once you understand this principle, you understand why prices fluctuate, how supply shortages affect inflation, and why governments are concerned with maintaining balance in these systems.

Phases of the economic cycle explained

Economies do not grow linearly. Instead, they experience predictable cycles consisting of four distinct phases:

Expansion phase: After a crisis, markets emerge renewed. Demand for products increases, stock prices rise, unemployment falls, and investment flows freely. It’s the optimistic moment when everyone believes in the future.

Boom phase: The economy reaches its maximum productive capacity. Prices stabilize, but signs of weakness begin to appear: some small companies disappear through acquisitions, sales slow down. Paradoxically, the market remains positive on the surface, but underlying negative expectations are germinating.

Recession phase: Negative expectations become reality. Labor costs rise, demand drops sharply, corporate profits contract, and stock prices decline. Unemployment rises again, precarious part-time jobs emerge, and incomes erode. Investment practically disappears.

Depression phase: This is the most critical stage. Deep pessimism invades markets even when there are positive signals. Companies go bankrupt en masse, interest rates soar, unemployment reaches historic highs, and the value of money collapses. Finally, when it hits bottom, the expansion cycle begins again.

Types of economic cycles and their duration

Although the four phases mentioned occur repeatedly, their durations vary considerably, giving rise to three types of cycles:

Seasonal cycles: The shortest, lasting just months. Still, they strongly impact sectors like tourism, agriculture, and retail. Their main characteristic is predictability: we roughly know when they will occur.

Economic fluctuations: Last for years and result from imbalances between supply and demand, with delayed effects. Economic problems are often only detected when it’s too late to prevent them. They are unpredictable, irregular, and can cause severe crises that take years to resolve.

Structural fluctuations: The longest cycles, spanning decades. They result from profound technological and social transformations. They cause mass unemployment and generational poverty but also drive revolutionary innovation that eventually creates new prosperity.

Factors driving the functioning of the economic system

Dozens of variables influence the economy simultaneously. Some of the most significant include:

Government policies: Governments have two main tools: fiscal policy (decisions on taxes and public spending) and monetary policy (control of money supply and interest rates by central banks). Through these tools, they can stimulate depressed economies or cool overheated ones.

Interest rates: Determine the cost of borrowing money. Low rates encourage credit for businesses, housing, education, stimulating the economy. High rates discourage borrowing, cooling economic activity. This instrument is especially powerful in developed countries where credit is central.

International trade: When two nations have complementary resources, trade benefits both. However, it can also displace local jobs in industries that cannot compete globally. Openness to trade is a double-edged sword with clear winners and losers.

Technology and innovation: Technological revolutions generate new industries, destroy others, and increase overall productivity. Although initially causing sectoral unemployment, they ultimately raise living standards in the long run.

Expectations and confidence: Collective psychology matters. If consumers and entrepreneurs trust the future, they spend and invest. If they distrust, they tighten their wallets, and the economy contracts, with expectations becoming self-fulfilling prophecies.

Microeconomics vs. Macroeconomics: Two perspectives on economic functioning

There are two complementary ways to analyze the economy. Microeconomics examines individual parts: how a company sets prices, how consumers respond to price changes, how a specific market functions. It’s the “bottom-up” analysis.

Macroeconomics looks at the big picture: total country growth (GDP), national unemployment, inflation, international trade balances, exchange rates. It’s the “top-down” analysis that considers entire economies and global interactions.

Both perspectives are essential. Without understanding microeconomics, we don’t grasp how individual decisions aggregate. Without macroeconomics, we don’t see the trends affecting everyone simultaneously. True understanding of how the economy works requires mastery of both levels.

Conclusion: Mastering economic concepts

Economics is a living, dynamic, and deeply interconnected organism that determines collective prosperity. Its functioning rests on fundamental principles: supply and demand, predictable cycles, multiple influencing factors, and two complementary analytical perspectives.

While the complexity is real, the core concepts are understandable. By mastering these fundamentals, you can anticipate trends, make smarter financial decisions, and consciously contribute to the economic landscape we all share. Economics is not an impenetrable mystery but a rational system that rewards understanding and adaptation.

Key questions about economic functioning

What is the essential function of the economy?
The main function is to organize the production and distribution of scarce resources to meet human needs. It’s a coordination mechanism that enables specialization and trade, raising overall living standards.

Why is the economy cyclical?
Economies are cyclical because they rely on expectations that self-fulfill. When optimism reigns, people spend and invest; when pessimism dominates, they withdraw. These sentiment shifts generate the boom and bust phases we observe regularly.

How do my personal decisions affect the overall economy?
Every purchase you make contributes to demand, influences prices, and sends signals to producers about what to manufacture. Multiplied by millions of individual decisions, personal behavior shapes macroeconomic direction, creating a continuous feedback loop.