How the Economy Works

An economy is all the ways people produce, buy and sell goods and services. Because time, money and materials are limited (economists call this scarcity), we have to make choices. Prices help coordinate those choices.

• Demand is how much buyers want at each price. When the price goes up, people usually buy less. That's the law of demand, and why the demand curve slopes down.
• Supply is how much sellers will offer at each price. A higher price makes it worth producing more, so the supply curve slopes up.
• Where the two curves cross is the equilibrium: the price at which the amount people want to buy equals the amount sellers want to sell.

A change in price moves you along a curve. A change in anything else shifts the whole curve. Shifts are what change the equilibrium price.

Shortages and surpluses. If a price is held below equilibrium (say, by a price cap), people want more than sellers offer: a shortage. Held above it, sellers can't sell it all: a surplus. In a free market, those gaps push the price back toward equilibrium.

Inflation is a general rise in prices across the economy, so each dollar buys a bit less. One pricier item isn't inflation. Most prices rising together is. The opposite, a general fall in prices, is deflation.

The best-known measure in the US is the Consumer Price Index (CPI), published monthly by the Bureau of Labor Statistics (BLS). It tracks the price of a “basket” of goods and services that urban households buy: food, housing, gas, medical care, clothes and more. The inflation rate you hear in the news is usually the CPI's change over the last 12 months.

• Too much demand (“demand-pull”): spending grows faster than the economy can produce.
• Rising costs (“cost-push”): energy, materials or wages get more expensive and businesses pass it on.
• Expectations: if everyone expects prices to rise, workers ask for raises and firms raise prices, which can keep it going.

The Federal Reserve aims for 2% inflation over time, measured by a related index (PCE prices). A little inflation is considered healthy; high or unpredictable inflation hurts savers and makes planning hard.

The Federal Reserve (“the Fed”) is the central bank of the United States. Congress gave it a dual mandate: maximum employment and stable prices. It also oversees banks and keeps the payment system running.

Its main tool is the federal funds rate, the interest rate banks charge each other for overnight loans. The Fed's Federal Open Market Committee (FOMC) meets eight times a year and sets a target range for it. That rate ripples out to credit cards, car loans, business loans and savings accounts, and influences mortgage rates.

Why it takes time. Rate changes can take many months to fully affect the economy. That's why the Fed watches forecasts, not just today's numbers.

Separately, fiscal policy (taxes and government spending) is decided by Congress and the President. The Fed handles monetary policy.

Gross domestic product (GDP) is the total market value of all final goods and services produced in a country in a period. In the US, the Bureau of Economic Analysis (BEA) publishes it every quarter. It's the broadest single measure of how big the economy is and whether it's growing.

Consumer spending is the biggest piece of US GDP by far, about two-thirds.

• Nominal GDP uses today's prices. Real GDP removes inflation, so it shows whether we actually produced more. Growth figures in the news are real GDP, usually stated as an annual rate.
• GDP per person divides by population, a rough guide to average living standards.
• What GDP misses: unpaid work like caregiving, how income is shared, leisure time and environmental damage.

Economies move in a business cycle: expansions (growth) and contractions. A recession is a significant, widespread decline in economic activity lasting more than a few months.

The “two quarters” myth. Two quarters in a row of falling real GDP is a popular rule of thumb, but it's not the official US definition. Recession dates are set by the National Bureau of Economic Research (NBER), which looks at many measures together: jobs, income, spending, sales and production. It often announces a recession months after it starts.

Unemployment

The unemployment rate is the share of the labor force who don't have a job but are available and have looked for one in the past four weeks. The BLS publishes it monthly in the “jobs report,” based on a survey of households.

• Frictional: between jobs or just starting out. Normal and healthy.
• Structural: skills or locations don't match the jobs available.
• Cyclical: caused by a recession, when demand falls and employers cut back.

People who've given up looking aren't counted as unemployed, because they've left the labor force. That's one reason economists also watch the share of adults who have a job.