Exactly, how does the economy work?

If you can remember those mid-morning and long afternoon lessons/ lectures that somehow always used to drag and you were questioning the relevance of the topics being taught at school or at University, then you will really be keen on answering the question above…

coverFrom time immemorial, no one can really put a finger on how the economy works to the letter, but with the advent of the information age, we can safely say that an economy is simply a machine.A machine that can be switched on or off, a machine that can have its efficiency improved or reduced and above all, a machine that can have its effectiveness altered by careful tweaking based on scientific and mathematical formulae derived and devised by people known as Economists. Whereas other economists might argue differently, I believe that this simple description of the economy as a machine is based on a simple belief that what we learnt in the lecture halls and in books is a different form of academia and can always be watered down to become simpler.

I just happen to be one of those so-called Economists, and I can confidently say that an economy is indeed a machine that is purely based on demand and supply.

I must re-iterate that this is not an economics lesson, but rather a debate for simplification of some things economically-speaking.

Any economy is based on what is traded and these trades are in the form of transactions. A transaction happens when you as a buyer gives money to a seller in exchange for a good or a service rendered unto you. The sum of all these transactions is quite complex and that is what makes the economy complex. An economy consists of all of the transactions in all of its markets. So, while seemingly complex, an economy is really just a billion simple things working together, which makes it look more complex than it really is.

In the run-up to debating this article, my former classmate and current Economics-PhD-Student Enoq argued with me in a lengthy phone conversation that my article needs to argue on the tenets that when you switch on a machine, it must be powered for long so that it stays working. Any economy involves 2 main buyers; these are the Government and the Private sector. What they use to pay for the goods and services is what powers the machine. Money. But you see money is in two forms. Cash and Credit. Hence there always being a market for both money and credit… The money markets and the credit markets usually intercede with the same buyers and sellers… Central Bank, Commercial Banks and Government paper et al…

The sum of all these transactions is the GDP of an economy and though many other economists are debating about its actual applicability as a measure of an economy’s growth levels, a newer and more acceptable measure has not yet been fully received.

GDP = consumption + gross investment + government spending + (exports – imports),

or

GDP = C + I + G + (X-M)

Roles of the machine:

The role of the machine is to establish formal relationships among people as their daily business of living. The machine is as good as the relationships that people have with each other in society on a daily basis. They are optimistic and are keen to interact with each other and work hard to be creative and innovative in order to improve things. The machine is bad when people become pessimistic and feel demotivated to put in effort because they feel that there is danger out there or that there is grave injustice in society. The underlying motivating force of society therefore has an important impact on the future of the economy.

So after looking at some of the roles or the machine, we can say that for it to be efficient, it must be able to connect people to other people, companies to other economies and Governments to other Governments. As mentioned previously, an economy is simply the sum of the transactions that make it up. Depending on who is in-charge of this machine and what objectives they want this machine to achieve, it is imperative that there should always be some form of control commonly known as regulation. Different Economists argue from different schools of thought and all claim to have a unique or better proven idea of having the machine work. Let it be known that the biggest role of the machine in connecting people is making sure that it distributes the existing resources optimally.

Translation ~> Transactions should be shared equitably amidst their relative scarcity.

Efficient Economy vs Effective Economy

This should be the real focus of debate and yet it rarely is. Somewhere along the way, many of us forgot not only how economies work, but also the proper role of government. Economy is a natural part of life. As we all know, there simply are not enough resources and products available in the world for us all to have all we want at a zero price. The reality is that resources are scarce relative to our wants and desires; therefore we are forced to make choices as we seek to satisfy our wants. Choosing one alternative generally means giving up a host of other options. In our choices we first satisfy those desires that we find most pressing.

An efficient economy thus implies an economic state in which all resources are optimally allocated to serve each person in the best way while minimizing waste and inefficiency. When an economy is economically efficient, any changes made to assist one person would harm another. In terms of production, goods are produced at their lowest possible cost, as are the variable inputs of production. This is very theoretical as it is very difficult to please everyone. An effective economy on the flip side is one in which there is competition in assisting of the allocation of resources.

The market structures should in effect be governed by some rules and an impartial referee of sorts. These are imperative in helping to re-distribute resources.

Case in point; when the transactions are left to be managed by few people, they end up becoming self-servant-ish and less concerned about the rest… hence some rules and a regulator

Who then controls this machine?

That is the question of the ages. CPFChange_Economy2

Depending on which side you are looking at, a large chunk of the so-called machine’s transactions are handled and effected by the Government of the country in question. In this case, is called a centralised economy whereby all transactions usually begin and end with the government.

On the other side is the private sector which comes in as a key enabler of these transactions and thus shall never be left out of the workings of the machine. ~>mainly because of the effectiveness with which they seem to operate the machine<~

Most times, the machine is sub-divided into sectors that form its main parts.

These sectors are;

  • Agriculture: Farming to produce foods like coffee, cotton, maize, wheat, meat, fruit and vegetables.
  • Manufacturing: the production of goods in factories. This includes a wide range of products such as food, beverages, tobacco, textiles and clothing, wood and paper and their products, petroleum products, metals like steel as well as machinery and metal equipment, electrical goods, transport equipment and furniture.
  • Utilities: This category includes electricity, water and fuel supplies to the community and to industry. This infrastructure and services are usually provided by the state.
  • Construction: the building of houses, roads, bridges, factories, office blocs, shopping malls and other buildings.
  • Finance: The institutions that hold the savings, or surplus wealth, such as banks, pension fund, the insurance industry. The products these institutions sell to the public (such as life insurance, bank accounts etc.) account for a significant proportion of the goods and services produced in the country. Uganda’s financial sector is on a steady growth pattern as evidenced by a growth in almost all key indicators in its financial sector.
  • Government: All government taxation and spending is part and parcel of the economic interactions in society. Government contribution to GDP can be divided into the following types of economic interaction (a) transfers: where the government takes money from one sector the economy and give it to another, e.g. child support grant (b) consumption the paying of salaries and other recurring costs that keeps the system of government moving (c) investment, where the government builds new infrastructure.
  • Retail: The official name for this category is wholesale, retail, and motor trade; catering and accommodation. It includes the shops, the restaurants, the hotels and other services that consumers use every day. (Do you think Kikuubo shops are included in this figure? How much would you guess they accounted for in the economy as a whole? )
  • Transport: This is actually both transport and communications. The moving of goods and people throughout the country by rail, road and air. The communications sector includes MTN, uganda telecom, Airtel and other operators.

There are some challenges involved in managing the machine. In every country, the government takes steps to help the economy achieve the goals of growth, full employment, and price stability. In Uganda, the government influences economic activity through two approaches: monetary policy and fiscal policy.

Through monetary policy, the government exerts its power to regulate the money supply and level of interest rates. Through fiscal policy, it uses its power to tax and to spend.

Key takeaways

In this discussion, we’ve touched on a few key things in trying to understand how the economy works:

• The economy is a machine that needs to be powered with a fuel to keep it going…

• The size of the economy can be represented by transactions

• The use of the machine is to connect people, companies and the government to effect many more transactions • The machine should operate within some form of rules and governance to allow it not be overtly used for selfish conduct

• The machine is sub-divided into sectors that individually are important to making it achieve its objective of connecting for more transactions.

• Many a time, if the machine is struggling, the government may borrow money that will form its National Debt from locals through the treasury and bonds markets.

• The cumulative sum of deficits is the national debt—the total amount of money owed by the government.

• The Central Bank is key in checking how much money is available in the market for transactions using Monetary Policy

 Monetary policy is used to control the money supply and interest rates.

 It’s exercised through an autonomous regulator aka the Central Bank, which has the power to control the money supply and interest rates.

 When the Central Bank believes that inflation is a problem, it will use contractionary policy to decrease the money supply and raise interest rates; to counter a recession, it will use expansionary policy to increase the money supply and reduce interest rates.

• Fiscal policy is used by the government by checking its power to spend and tax.

 When the country is in a recession, the government will increase spending, reduce taxes, or do both to expand the economy.

 When we’re experiencing inflation, the government will decrease spending or increase taxes, or both.

 When the government takes in more money in a given year (through taxes) than it spends, the result is a surplus.

 When the opposite happens—government spends more money than it takes in—we have a deficit.

Edmund KamugishaEdmund is the Engagement Director at BLEGSCOPE®, and has over 9 years of management consultancy experience notably in MSMEs, FMCG companies and in the service industry. You can follow him on twitter: @edmokmg

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